The system view of Australian house prices

All facets of Australian housing get a lot of media attention and has done so for as long as I can remember.

In my opinion Australia has completely fractured its economy with the obsession and, slowly but surely, perverse systemic evolution has occurred to support ever growing prices of a non-productive asset.

Australian Housing is an “unquestionable” asset class that now burdens the economic, social and political system of Australia. Australia House prices are so engrained in the national psyche that any suggestions of price falls are often met with what only be described as an evangelical and cult-like response.

There is a plethora of social comment on the impacts Australian house prices, so I do not intend to cover this angle, but what I will say is it is considerably harder for a young Australian today to secure housing than it was in the past decades and anyone who says otherwise is lying to you, and probably themselves.

In terms of economic methodology, the entire situation is a disaster. This is nothing like the situation a country that targets GPECS would find itself in.

From an economic system perspective, 99% of the sphere of commentary is about the demand side , predominantly immigration, supply constraints, negative gearing and capital  gains. Again, this has been well covered across the media and other sources, so I won’t cover it  here, but only to say that giving tax breaks and other subsidies to investors that are not available to young families for housing is just grossly stupid an inequitable policy.

What I do want to talk about is he distortion of the economic landscape that is very rarely mentioned.  From a whole-of-system perspective, Australian housing has grown like  cancer with its hidden tumors now invading all forms of policy and regulation, much of which is never spoken about, isn’t understood and/or goes undetected. 

Let’s start with Super.

The Australian superannuation system  is basically a forced retirement savings scheme for Australians in which employers must pay a proportion of wages directly into employees retirement fund. It has evolved over many decades and is seen as a “world class” system . It is underpinned by what is now called the “super guarantee”. 

There are significant issues with the system , it like housing policy has grown in inequity over the years, and it is rather unclear that it is delivering the originally intended outcomes. But I will have to leave that to another post.

What it does mean is that there is a huge, guaranteed and ever-growing investment fund that sits aside the Australian economy. But in Australia, a capital shallow country with a relatively small population, where to invest ? 

And this is where the problems begin. 

Overall a national forced retirement investment fund is a great policy, but once you scratch beneath the surface you start to see what is happening, namely this:

The highest allocation to equities at around 50% (same as the US) of the 22 countries,

with Switzerland and Netherlands as low as 33% and Japan 30% .

And if you look at the asset allocation of a default option in an Australian super account you will see why.

So everyday a not insignificant percentage of private sector income is added to the pile and, via asset allocation, ends up in the Australian equity market with a smaller proportion, but still rather large amount, buying bonds.

As I said above , Australia is capital shallow so there isn’t a large innovative industrial base to invest in so the inevitable outcome is extraordinary valuations of the banking system operators (ADIs).

Capital flowing to banks supports their ability to lend. As there is limited productive investment in the country this leads to the only other possible outcome. An incentive to massive private sector lending into a speculative asset class, in Australia’s case, driven by many factors ,  it landed in housing.

So captured super drives unproductive loans.  Now for the tumor in the banking system.

As I posted back in the Macro 101 series banks have capital requirements that are in place via  regulation to insure banks have necessary capital to buffer themselves for losses.  Do not confuse this with Lending Mortgage Insurance(LMI) , which is another disaster to discuss another day, this is internal capital the banks must hold against its assets i.e. loans.

There have been global efforts after the GFC, through Basel , to attempt to raise standards, but these are mostly to do with reporting rather than serious changes in methodology.  There are now slight differences in the required capital structures for banks and a slight increase in the percentage of capital required against risk weighted assets. But on a whole I consider Basel to be  lipstick on a pig.  So why do we care ?

As per the above chart banks need to hold around 9% capital vs asset. On the surface a bank needs $9 of capital to support $100 in loans. Seems reasonable ? But here is the kicker. 

If you bother to read the APRA's actual documentation on capital adequacy you will stumble across this chart.

And this point.

19. An ADI must calculate the RWA of an on-balance sheet exposure by multiplying the current book value of the exposure (including accrued interest or revaluations, and net of any provisions for defaulted exposures, partial write-off or associated depreciation) by the relevant risk weight. 

So, as you can see, the lower the LVR of the loan (House price vs loan value) the less capital that is actually required to back it up and the ADI must continually updates its "current" exposure to risk weighted assets. 

In layman's terms ,in regards to residential property loans, this means "constantly re-evaluation the value of the housing market and if by some luck the value of housing has increased then the banks need less capital to back it up". 

So there you have it.

Captured Super drives loans, loans drive property prices, and by some "interesting" macroprudential ruling , property prices drive the need for less capital which drives more loans which drives property prices. And remember it is all there to pay for he retirement of Australians.

Without even mentioning all of the demand side policy ( measurably high immigration, limitation of supply via many factors, capital gains, negative gearing , first home buyer grants etc ) the system is already designed to push prices every higher. And, as you can see from above, all the risk lands on the Australian public because all of this is "too big to fail". 

It isn't "a" system, it is "the" system. 

More on that in another post.

Macro 101 - Balance of payments

Another key macro concept is in the balance of payments for a nation as it can quickly provide a macro overview of the structure of a country's economy. 

As you may know I tend to describe the economy in 3 parts, the government sector , external sector and the private sector. The reason I do this is because it fits with the national accounts data and the national accounting identity of sectoral balance.

For those who aren’t sure about the sectoral balance equation you can read this article, but the basic premise is that there is an accounting rule flowing for the calculation of national GDP that states that there is a direct and unbreakable relationship between the government budget balance (deficit/surplus), the external sector balance ( current account ) and the private sector (businesses and households) budget balance over an accounting period.

For reference here is the Australian government sector balance as a proportion GDP since 1979 through late 2024:

The balance of payments data is basically a balance sheet of our nation’s net borrowing or supply, in dollar terms of goods, services and financial assets, to/from the rest of world. The major component of the balance of payments is the current account:

You can see Australia began making net payments to the world sometime around 1974 and has never really looked back. COVID-19 impacts aside, the recent surge in Australia’s terms of trade stemming from the mining boom hasn’t been enough to get the account into the black.

So how can this be ? Well we need to dig a little deeper into the data to get the details.

The balance of payments is made up of three accounts. The Current Account, the Capital account and the Financial account.

a ) Current account

According to the ABS

Transactions between Australia and the rest of the world in goods, services, primary income, and secondary income are recorded in this account. It is distinguished from the capital and financial accounts.

The current account shows the net amount a country is earning if it is in surplus, or spending if it is in deficit, and it is called the “current” account because it covers financial transactions occurring “right now”, meaning these transactions don’t give rise to future claims.

The current account is broken down further into the balance of trade in goods and services, primary income and secondary income. You can see the breakdown of the account from the summary section of the latest balance of payments.

Balance of trade is self explanatory, while Primary income:

The primary income account shows primary income flows between resident and non-resident institutional units. The international accounts distinguish the following types of primary income:

• compensation of employees;
• dividends;
• reinvested earnings;
• interest;
• investment income attributable to policy holders in insurance, standardized guarantees, and pension funds;
• rent;
• and taxes and subsidies on products and production.

and Secondary income.

Secondary income include current transfers that offsets to the provision of resources that are normally consumed within a short period (less than twelve months) after the transfer is made. Examples include food aid, remittances from residents temporarily abroad, and remuneration received by international students undertaking university studies.

b) Capital account

This is usually a very small component of the balance of payments as it records both acquisitions and disposals of non-produced, non-financial assets and capital transfers. This includes things such as patents, leases and licenses for use of products, but not the actual value of any actual products themselves.

c) Financial Account

According to the ABS

This account records all transactions between residents and non-residents, associated with a change of ownership of foreign financial assets and liabilities during the period including the creation and liquidation of financial claims.

This account is further broken down into:

• Direct investment
• Reserve assets
• Portfolio
• Financial derivatives
• Other investment

So basically, when the external sector is in deficit the current account and capital accounts tell us how we are spending the money and the financial account tells us how we are funding the bill. 

The equation is

Current account + Capital account = Financial account

Which is why it is called the “balance of payments”.

So now you have the background let’s have a look at the data. If you have a look at the current account breakdown it is easy to see that the terms of trade are having a positive influence on the account. That is, in dollar terms, we are exporting more goods and services than we are importing.

However, what you will also notice is that our primary income is negative and of a greater magnitude than our balance of trade is positive. In other words, even though we are in the midst of a commodities boom money is still flowing out of the local economy via the external sector:

Which basically means that in aggregate Australia sends massive amounts of dividends and interest payments to the rest of the world. In fact it is so large that it is dwarves our trade in goods and services, resulting in a net loss to the external sector even during the historically high terms of trade. The most important thing to note is that these are payments stemming from previous foreign investments meaning Australia is continuously making payments to rest of the world somewhat independently of the balance of trade.

Finally, the financial account tells us that in order to maintain this current account deficit, Australia continually relies on foreign direct investment capital flows along with sales of equities, and ultimately it leads to a net debt position the rest of the world.

International Investment Position

Australia's international investment liability position was $716.5b at 30 September 2024, an increase of $20.6b on the revised 30 June 2024 figure of $695.9b. Australia's net foreign equity asset position increased $35.9b to $586.3b and Australia's net foreign debt liability position increased $56.6b to $1,302.9b.

 

    

Macro 101 - Private Sector Credit Impacts

In a previous post I talked about the sectoral balance equation which is fundamental to understanding how an economy functions at a macro level. The function is also useful to understand the likely high-level economic outcomes of monetary and fiscal policy changes made by a government.

If a government is running a surplus budget then they are taxing more than they are spending. This means that the private sector will be paying more money to the government than they are receiving. Unless the export sector is providing the offsetting value ( a positive trade balance ) then the private sector will be getting poorer and will have to take on debt to maintain the same standard of living in the absence of price deflation.

That debt is what I want to talk about in this post.

Private sector debt is something that seems to be ignored by many economists. I have no idea why because it is an important measure of a number of things at a macroeconomic level. As I said above, using the sectoral equation approach you can see that it can tell you when government taxation/spending levels are not appropriate to support maintaining a standard of living given the terms of trade of the economy. From a financial stability perspective debt can be an early warning that the private sector is overly investing in a non-productive asset class which may require changes in the economic policy framework to counteract.

One of the major issues with a high private sector debt burden is that it reduces the private sectors ability to invest and therefore contribute to an increase in the productive capacity of the economy. If the debt associated with non-productive investments is allowed to grow unabated then the productivity of the economy will decline as the capital available for productive investment diminishes.

In Australia the private debt level has become so large that the banks can no longer fund it domestically within the regulatory framework. This now leaves the economy open to a foreign funding liquidity risk, something that flared up during the GFC and may occur again at some time in the future. 

However what is less understood by most economists is the effect of the rate of change of debt issuance on the economy. Loans create deposits, not the other way around, which can be used to pay down existing debt or used to purchase goods and services. When they are used to purchase goods and services they add to the overall economy by creating economic activity (resource utilisation). This has a flow-on effect of creating jobs and creating economic growth.

But make no mistake, continual debt issuance is unsustainable without offsetting productive economic improvements. So if that credit is being invested in non-productive enterprises then there will come a time when the private sector simply cannot and/or will not take on additional credit because the underlying real economy cannot support it.

When this occurs then the effects we mentioned above works in reverse. The fall in credit issuance creates less deposits, which drives less economic activity. This has a flow-on effect of destroying jobs and making the economy weaker.

Macro 101 – Sectoral balance

You may not know that much about economics, and possibly even less about macro-economics. But if there is one formula you should know, it is the equation for sectoral balances.

Don’t get overwhelmed by the look of it. What it basically says is that there is a direct and unbreakable relationship between the government budget balance, the national trade balance and the private sector budget balance.

So what! Why is that important?

Well what it also tells you is that total change in private savings over a period are equal to private investment plus the government budget balance plus net exports over that period, and that this is always true. Although at first this formula may seem relatively unimportant, once you understand its consequences it becomes very powerful. 

Here is the reason;

If in an accounting period there is a trade deficit and a government budget surplus then there MUST be a private sector deficit. By private sector deficit I mean a period where there is a net loss of savings from the private sector. If this situation continues for a period of time then it leads to increasing indebtedness.

The reason this is formula is so powerful is that it allows you to make a very quick analysis about whether macro-economic decisions actually make sense and, at a high level, determine the likely outcomes of those decisions. That does not mean that this is the “magic” formula, because there may exist some other compensating factors in the economy that you are unaware of, but it certainly is a good place to start.

It also provides input into the comparative "money centric" vs "GPECS centric" view of economic policy as discussed in another post.

Macro 101 - Reserves and interest rates

So before I start I need you to ask yourself two questions.

1. What does the term “reserve” actually mean in the title “Reserve bank of Australia” ?
2. How exactly does the RBA control interest rates?

If you know the answer to these questions then maybe you don’t need to read on. Otherwise let’s dive in.

I will be working through transactions step-by-step in order to slowly add complexity. I will obviously be over simplifying examples, and in some cases change the order of how things that actually occur in in order to explain things more simply. But none of these things change the actual functions/tasks that are occurring, it just makes it easier for me to explain the process.

In another Macro 101 post on banking credit I talked about “money of account” and “money of exchange”. If you get stuck with these concepts while reading this post please go back and read the previous post for more detail.

From the beginning then…

You decide to purchase a car from a dealer for $40,000, the dealer banks with CBA, you bank with ANZ. You approach ANZ for a loan and given your wonderful credit rating you are approved. The steps of the transfer are as follows:

• The ANZ creates a new loan record and assigns it an outstanding balance of $40,000 under your name.
• At the same time it adds $40,000 to your account.

So far this entire transaction is internal to the bank. This is simply a change in the database that the bank uses to store account information. So although you think you have an additional $40,000 nothing has really happened apart from a few electrons have been re-aligned on a hard drive(s) somewhere inside the ANZ’s data-centre. This is “money of account”.

So next you want to pay the car dealer who banks at CBA. To do this you could use a bank cheque, personal cheque, cash, money order etc. It really doesn’t matter how what the medium of transfer is. However what you will note is that the electrons that were re-arranged on ANZs hard-disk(s) have no value to the CBA. So how exactly does ANZ transfer $40,000 to CBA in order to satisfy the transaction? Enter “money of exchange” otherwise known as “reserves” which are recorded on the reserve bank’s computer.

Banks transfer reserves to and from each other via their reserve banks accounts. In Australia they are called Exchange Settlement Accounts and you can read about them here.

In future examples I will refer to these as “reserve accounts” for simplicity but it must be noted that in fact an ESA is a special type of reserve account that is only available to banks that have access to the interbank lending markets. There are other reserve accounts that are used by foreign central banks to record their AU$ reserves.

Now let’s describe the transaction that occurs for you to purchase that car.

• You give the car dealer a cheque for your car.
• The dealer takes the cheque to CBA and deposits it in his/her business account.
• CBA processes the cheque and demands $40,000 of reserves from ANZ
• At the ANZ the balance of your account is deducted by $40,000 and requests the RBA move $40,000 from its reserve account to CBA’s reserve account.
• At the CBA the car dealers account is adjusted by $40,000

So now we have 3 sets of electrons being re-aligned. Firstly at ANZ the account database is once again updated to record that your account has lost $40,000. The database at the reserve bank is updated to record that $40,000 of reserves was deducted from ANZ’s exchange settlement account and added to CBA’s exchange settlement account. Finally at the CBA, their database is updated to show that your car dealer has an extra $40,000.

Functionally the same process occurs if you used cash. Because a $5 note is simply a plastic/paper version of a $5 reserve balance and are completely interchangeable.

Now obviously you are not the only one doing a banking transaction that day, there are in fact tens of millions of inter-bank transactions each day in Australia. Each one affects the account balance in each bank’s reserve account. Over the period of the each day the balances of these accounts will fluctuate but the RBA specifies that these accounts must have a positive balance at all times ( more on that point later ).

The important thing to understand is that the amount of reserves required is much smaller than the total of the bank’s “money of account”. For example, if on the same day your loan and cheque were processed, a $40,000 loan was issued by CBA and a subsequent cheque given to an ANZ customer then technically there would be no change in either banks reserve accounts even though both banks issued $40,000 loans.

But in reality that is not normally the case. When a bank runs a loan book it requires reserves in order to support interbank transfers and over the counter transactions because of the demand for the “money of account” that those loans created when they were issued.

So as a bank issues loans it must seek reserves to support its liquidity requirements due to those loans. So there will obviously come a point when a bank simply does not have enough reserves to support additional loans. The bank therefore has two choices; stop issuing more credit until some existing loans are repaid, that is some reserves are returned to the bank, or borrow reserves from someone else.

Obviously banks want to continue to grow their loan book because loans are profitable, so 99.99% of the time banks seek additional reserves.

Banks can only get more reserves from two places, other entities that have an ESA or from the reserve bank itself. 

That is the RBA is a bank for banks. It is where they store and borrow Australian dollar reserves. That is why it is called the “Reserve bank of Australia”. (Question 1 above ). All across the globe there are similar institutions for each unique currency. The US has the Fed which records US reserves, China has the PBoC which records Yuan reserves, the EU has the ECB which records Euro reserves, and so on. At each of these institutions, foreign central banks also have non-EAS reserve accounts. These accounts are used to support international exchange and trade.

So let’s look at what happens when the CBA issues AU$1 billion 5-year bonds and a US superannuation fund purchases them. We will assume that the fund already has $AU1 billion equivalent of US$ in a US savings account at the Bank of America, and that the exchange rate is 1.00. Again this has all been oversimplified.

• The fund agrees to buy the bonds and instructs the Bank of America to pay the CBA $1billion Australian dollars.
• At the bank of America the balance of the savings account in their computer in the name of the superannuation fund is lowered by $US 1 billion.
• The Bank of America then transfer $US 1billion dollars of its reserves to the Reserve Bank of Australia’s US reserve account (non-ESA) under an order to issue the equivalent amount (governed by the exchange rate) of AU$ to the CBA.
• At the same time the Reserve bank of Australia adds $AU 1billion to the reserve account of the CBA in its computer.

So let us recap. $US1 billion of “money of account” was subtracted from an superannuation funds’ account in the database of the Bank of America, $US1billion of reserves was transferred from the reserve account of the Bank of America to the reserve account of the RBA in the database of the US Federal reserve, and finally, $AU1 billion was added to the balance of the Exchange Settlement Account of CBA in the database at the RBA. 

The CBA now has another $1 billion dollars worth of loan liquidity supporting reserves, and the RBA has gained $1US billion dollar of US reserves.

As you can see from that example the CBA actually got its reserve from the RBA because it is in fact the only place that could issue them. This is because reserves are simply electronic records in the RBA’s computer, which is why no one else can issue them. This may sound like a trivial statement, but it is in fact the basis on which modern economies are built.

Moving on… Obviously over time the CBA must pay interest on those bonds, which will move a proportion of those reserves back in the opposite direction, but by this time the loans that these bonds support will have matured somewhat so new reserves will exist to make those payments. At the time of bond maturity the entire process will be reversed meaning that $AU1 billion worth of reserves would be removed from the bank’s ESA. You may now appreciate why banks must continually rollover funding and are therefore constantly susceptible to liquidity risk.

There is however a fairly large problem with the fact that a bank suddenly receives $AU1 billion dollars in reserves because it has suddenly flooded the interbank market with reserves. This would tend to drive down interbank interest rates which would undermine the RBA’s interest rate.

This leads nicely into a discussion about the interbank lending market and how the RBA controls interest rates through it. I was previously going to write about this myself, however it turns out that the RBA has a very good document available explaining it all for me.  

RBA - Domestic Market Operations and Liquidity Forecasting

The one issue with that document is that it required you to have some background knowledge of reserves and exchange settlement accounts before you read it. I hope I have done a fair job of explaining these concepts to you. If that is the case then you hopefully will not struggle too much with the following document.

The added bonus is that this is directly from an actual reserve bank so it supports the idea that I didn't just make all this up!

Macro 101 - Rethinking fiscal policy in line with GPECS

In this post I talk through the major arguments used to refute many of the core foundational topics mention on this blog.

They tend to come in two general arguments.

1. The way in which many chartilists model the monetary system is not representative of how modern government processes work. Separation of fiscal and monetary policy control is an economic safe guard and these models do not work without this separation removed.
2. Chartlism is just about "printing money" which leads to Zimbabwe type hyperinflation. Printing money taxes cash holdings (capital) through dilution/inflation whereas balanced budgets tax income.

In terms of 1, I completely agree.  The current structure of hamstringing fiscal policy with concepts like "required balanced budgets" and the like, absolutely leads to the requirement of separation of authority. Secondly I agree that these are protections of the financial system from political stupidity. However I do not believe that these are legitimate excuses to get poor economic outcomes  when there are already other options available within the existing monetary system. In addition they are falsehoods based on a general misunderstanding of how the current monetary system actually works. And let's not pretend the current arrangements don't already lead to terrible politically driven outcomes.  I am sure to discuss this more on this blog over time.

In terms of 2. There is a longer answer as it is just wrong.

This blog was created to educate people on how the current monetary system works in a modern economy and explain the potential of the economic system that exists today. By firstly understanding, and secondly re-thinking,  the system we can provide better economic outcomes for all citizens. 

It is however obvious that the political class in all modern nations understand how their economy actually works, so we are currently bound by the constraints of classic economic thinking which is in fact completely disconnected from how the system actually functions.

This blog, among many other things, will hopefully help explain what “money” actually means in a modern FIAT currency economy with a floating exchange rate from a unique perspective, that of the monopolistic issuer.

These concepts that are completely foreign to most people, but once you understand them you can appreciate a very different perspective on economic topics. From this context money has no real value; it can be created or destroyed at any time , as it actually is in the real economy. 

Money is simply a tool to drive outcomes. The value of these outcomes I propose we measure in GPECS.

GPECS is gained by using policy to manipulate the supply of money to and from the private sector ( via the banks ) to ensure that resources are mobilised in such a way to create sustainable growth , productive gains, employment , social well-being and national self sustainability.

If you had this perspective on “money” then you would have a very different view of deficits, national debts and the supply of money. As a monopolistic currency issuer (MCI) can issue their own currency at anytime they can obviously spend money at will. Likewise, they can do the opposite, that is, raise taxes and simply destroy the money knowing full well they can create more, out of thin air, the  next time it is required.

So back to the question. "Isn't this just printing money that will lead to hyper-inflation?"

Yes... and No. 

The question as it is phrased relates to money from a private sector perspective and therefore whether the Federal Government should be running a balanced budget, which means attempting to equal out the amount that it spends and saves (taxes) over the long term. In terms of a private household budget this makes sense, but in terms of a MCI it is meaningless, and in some circumstances very dangerous.

As a MCI if you are mindlessly issuing money at a time when the economy does not require it to utilise resources then you will cause damage to the economy, by inflation , and most probably by creating speculative bubbles; in the same way that you will cause damage if mindlessly tax people (de-issue currency) when it is not required.

So the answer is No. The government should never “just” print money. But there are times when there is a need to utilise resources and/or change the way resources are used and in some cases this may require the MCI to add additional money to the system, knowing full well that it can remove it at a later date via taxation or other methods if required.

But let us re-iterate once again. The aim is GPECS, if you issuing new money into the economy which cannot absorb it productively or without the policy frameworks in place to ensure that that money will in some way increase productivity, productive capacity, employment, social calm or drive future self-sustainability then it is going to cause problems. Stimulus for stimulus sake is an utter disaster, and in most cases simply leads to non-productive asset speculation, and inflation.

The main part of the criticism is the difference in outcomes when money is the focus versus GPECS. A money centric government sees government debt as the primary issue, believing it is bound by its money; a MCI sees growing GPECS as the primary issue, believing it is bound by the available resources.

Let us give you an example to explain the difference. Let us imagine we have a country that has just had some form of economic shock; unemployment is rising and the economic output is falling, due to this the taxation intake is falling and the social security bill is rising. Like all countries in the world we can assume they have an array of businesses and companies that produce goods of some kind, and have barriers and costs of/to production. For simplicities sake let us assume they had balanced terms of trade and political and social stability at the time of the shock.

The “money” centric approach.

A “money” centric government would have the budget as the primary focus, they would see the rising budget deficit due to falling taxation, and assume that the only thing to do is cut government spending and raise taxes. This in turn causes greater unemployment as the cut in spending and raising of taxes slowly steals private wealth and forces people to take on debt in an attempt to maintain the same standard of living. In this case unemployment is used as the countermeasure to attempt to “rebalance” the budget, and the fail safe is falling wage demands.

In the long term this would work to re-adjust the economy, but in the meantime many people would have lost their livelihood, been de-moralised and overall the only thing that has been fixed in terms of barriers to production is costs of wages ( i.e the standard of living of the populace fell ) and given this and the length of time that the economy floundered you would most likely be left with a deficit anyway. But note, most importantly, after all of this work to “fix” the economy the overall state of the country is in a worse position than it began.

The “GPECS” centric approach

A MCI would have the resource utilisation as the primary focus, they would see the rising unemployment and view it as an opportunity to reutilise those resources in a way to lower the current barriers to production. Their fiscal position is meanlingless.

In order to support GPECS, they would be holding public economic forums with business leaders and would have an agreed prioritised list of barriers to production, which could be addressed when resources were available to do this work. The government would initiate a number of these programs, including adjustments in taxation policy to support private investment in these programs.

These programs provide employment to the newly unemployed, with the end game to lower the current production barriers the economy faces, and therefore lower production costs and improve economy efficiency.

In this case “money” is used as the countermeasure to attempt to “rebalance” unemployment, and the fail safe being increased production.

In the long term this would work to re-adjust the economy, as the higher productive capacity flows through the economy then the government would lessened its input to these programs and jobs would start to move back into the private sector, increasing the tax intake.

Conclusion

As you can see from a “money” perspective the outcomes are the same, in both cases you would expect the budgets to eventually be re-balanced (although in the case of a GPECS government it is irrelevent) but the outcomes for the populace and the future of economy are very different.

Macro 101 - Bank Operations

Today I am going to talk about banks and how they operate in the context of macroeconomics and credit. I hopefully will not be introducing any ground-breaking concepts; this will just be an overall discussion of the processes.

However given my experience with the “average” citizen’s understanding of how the economy actually functions I will not be surprised if I shock a few people with the concepts I discuss below. At this stage I will try not to wander too far into the realm of the government as I want to leave that for another post.
Banking processes are important to understand because without them you have trouble reconciling other posts in the Macro 101 series.

Before I begin I need to introduce a little known monetary concept, types of money.

There are actually two types of “money” in a modern economy. There is “money” owned by the monopolist issuer, and there is other money. Money owned by the monopolist issuer is the only “money” that can be held in a reserve bank account. It is issued by the sovereign nation and is not backed up by any asset of corresponding value. This money is called “high power money” and is sometimes called “the monetary base”. I prefer to call it “money of exchange” for reasons I will discuss below. It is made up of bank reserves ( and equivalents ) and currency.

There is also another type of money called “credit money” which is sometimes called “money of account”. This is the money that is used within the walls of a financial institution but has no value to other financial institutions including the reserve bank.
Hopefully I have not confused you too much already. Please bear with me for just a little more background.

Unlike many other countries Australian banks have no reserve requirements. They are not required by legislation to hold any proportion of their deposits at the reserve bank. So anything you have heard about money multiplier theory is irrelevant to Australia. ( In fact it is irrelevant everywhere, but that is another story ). Banks in Australia have a capital requirement. To explain why I defer to the Reserve Bank of Australia(RBA).

An important part of the Bank’s prudential supervision of banks in Australia is the setting of capital adequacy guidelines with which banks must comply. A bank’s capital can be viewed as evidence of the willingness of shareholders to commit their own funds to a bank on a permanent basis, as interest free resources and, ultimately, as a cushion to absorb possible future losses. A strongly capitalised banking system engenders confidence in the banking and payments systems as a whole.

So how much capital do they actually require?

In line with international capital standards, Australian banks are required to maintain a ratio of capital to risk-weighted assets of not less than 8 per cent, with at least 4 per cent in core capital.

There are two type of capital in relation to capital requirements. Tier 1 capital ( otherwise known as “core” capital ) is basically stock ( at its current value ) and retained earnings. Those are earnings that have not been passed on as dividends to stock holders.

Tier 2 capital is basically loan-loss reserves ( known as “provisions” ) plus subordinated debt. Subordinated debt is long term debt that, in case of insolvency, is paid off after depositors and other creditors.

Assets held by the banks are risk weighted by their type and attributes. Risk weighting is actually fairly complex so I will simplify it for now. You can read APRA’s APS 112 Attachment C or check out the BIS site for an idea of how weightings are applied to various asset types.

Remember that loans are an asset to a bank while deposits are a liability. To simplify things lets say that currency and government securities are risk weighted at 0%, loans to other banks at 20%, residential mortgages at 75% and all other loans and lines of credit at 100%.

So if an Australian bank had $50 million in cash , $100 million in government securities, $150 million in interbank loans, $500 million in residential mortgages and $200 million in other loans then its risk weighted asset value would be $605 million. ($50m * 0% + $100m * 0% + $150m * 20% + $500m * 75% + $200m * 100%). As the banks requires 8% capital adequacy then this bank must have $48.4 million in capital to meet its requirement, with at least half of that value being Tier 1.

So now I have said all of that , let’s look at what happens when a loan is issued.

When a bank issues a loan of $250,000, it creates an asset and a liability on its balance sheet each of $250,000. The asset is the loan ( the IOU to be paid back by the mortgager) and the liability is the deposit that it creates in an intermediary account. This operation costs the bank nothing, just a few clicks of the mouse and a couple of taps on a keyboard and it has created $250,000 of “money of account” from nothing.

If the recipient of the loaned money is at the same bank then the bank simply transfers the money into that person’s account from the intermediary account and the transaction is complete. Again this cost the bank nothing. Overtime this loan will be paid back.; as it is the value of the asset ( the loan) will fall and the “money of account” will slowly be destroyed. It will go back to where it came from… Nowhere.

Although the issuance of the loan didn’t seem to cost the bank anything it can have 2 flow-on effects.

Firstly the loan is an asset; it therefore counts in the capital requirement calculations. The issuance of this loan may in turn require the bank to issue more subordinated debt and/or stock to cover its capital requirement position. I will not confuse this topic by discussing the implications of that.

Secondly, if the “money” from the loan needs to be transferred out of the bank then it must be converted from “money of account” into “money of exchange”. Remember “money of exchange” comes in two basic forms, currency and bank reserves. (Which are interchangeable).

If a member of the public wants to hold some “money of account” as cash, then the bank needs to transform it into “money of exchange” ( reserves ) in the form of currency. To do this it issues the person with the currency ( which lowers its reserves by that amount) and then lowers the person’s bank balance by the same amount ( lowering the banks deposit liability). When a person deposits currency at the bank the reverse occurs, the currency is converted into “money of account” by adding to the person’s account balance ( an increase in the bank’s deposit liability ) and the currency is added back to the bank’s reserves.

If the recipient of the loan is at another financial institution, then the lending bank must give up $250,000 of “money of exchange” and transfer it to the other institution. At the same time it removes its “money of account” deposit liability from its balance sheet.

Now the big question. How do banks actually “exchange” the “money of exchange”. The answer; through the reserve bank. Each Australian bank has an account at the reserve called an Exchange Settlement Account. These accounts are used to do all interbank transfers, but as I said at the top of the post, only “money of exchange” can be held in central bank accounts.

The RBA also stipulates that these accounts cannot not be overdrawn at the end of a banking day, and it is this little tiny rule that allows the government to control interest rates, or in other words the ” base price of money of exchange”.