By Jesus Felipe and Mariel Monica Sauler
A fundamental problem in the discussion of what the government does is the misunderstanding of how it pays for infrastructure, civil servant salaries, etc., and what happens to taxes.
When the Philippine government pays a contractor to build a road, a school, etc. it uses (every time) new money created by the central bank (Bangko Sentral ng Pilipinas or BSP). This is done “out of nothing,” ex nihilo. Pesos are not scarce, and hence cannot be treated as a resource like oil. This money is called “reserves balances” and the BSP is not financially constrained.
This is stated in RA 7653 (Central Bank Republic Act). The other way around, the taxes that we pay do not sit in a government account and wait to be sent back to us when it pays for a new project. Your bank transfers reserve balances to the Treasury’s account at the BSP. Taxes disappear in the process. The system in place (the same as in any other country) treats spending as a legal instruction to the BSP, and taxes as Treasury receipts, not funding instruments. Sections 89, 110, 113, and 114 of RA 7653, imply the following: a.) All National Government receipts are credited to Treasury accounts at the BSP; b.) All Government payments are made through the BSP; c.) Every Peso of reserve used to settle government spending is created by the BSP, not collected via taxes; d.) Spending is operationally a reserve credit decision by the BSP, subject to authorization, not funding availability; and, e.) Reserve availability is a policy variable, not a Treasury constraint.
Operationally, when Congress authorizes spending, Treasury instructs the BSP to pay, the BSP credits bank reserve accounts, and banks credit private deposits. Taxes reduce bank reserves earlier (banks need reserve balances before they can settle tax payments), increase Treasury deposits, and they are accounting offsets, not payments. Summing up: spending and taxation are separate and delinked operational processes. Taxes are not parked in a special account to be used to pay for infrastructure projects. No theory. It is the law, an operational reality.
It is true that the Philippine legal framework (budget process rules like PD 1177 and the Constitution) requires that the government have appropriations and revenue sources before spending. However, the requirement to have balances prior to spending does not mean that the government is financially constrained like a household or a firm. Payments proceed as explained above. We likewise emphasize that it is a mistake to think that taxes go back into the system to finance government spending. Taxes play several important roles in the economy (so we need to maintain them), but they do not finance spending. Taxes free up real resources in the economy (for the government) that otherwise would have been used by the private sector for private ends. They thus allow the government to spend without coming up against the inflation constraint that would be created once all resources are fully utilized.
So, what is the role of bond issuance if payments occur as explained above, and taxes do not finance spending? This brings us to the connection with the Bangko Sentral ng Pilipinas. Our central bank sets an interest rate to try to achieve its inflation target (its main goal and role), the so-called overnight reverse repurchase rate. This has been the backbone of our modern monetary policy since the early 2000s, together with the corridor system in place since 2016. What happens to this interest rate, key to managing the economy, and anchor of the interest rates in the banking system, when the government runs a fiscal deficit?
A fiscal deficit implies that there are excess reserve balances in the banking system (government pays us through the banking system and we pay taxes also through the banking system). This, invariably, puts downward pressure on interest rates, including on the central bank’s policy rate (to zero), not upward pressure, as many believe. The central bank cannot allow this to happen.
The solution? The excess reserves have to be drained. How? By coordinating with the Treasury department. It issues Treasury bills and offers them to the so-called primary dealers (major financial institutions), who are very happy to buy them because T-bills offer a great alternative to keeping the funds idle. It is just a portfolio exchange. Whoever thinks that bond issuance is an act of submission of the government with respect to the private sector should witness an auction in action. The government is clearly not borrowing from the private sector, much less in the sense that we are asked to believe, that the government is at the mercy of the private sector.
Apart from the fact that a fiscal deficit pushes interest rates downward, notice also that the initial possible inflationary impact of government spending (private spending is also inflationary) on prices is neutralized by the bond issuance, as excess liquidity (reserve balances) is mopped up. Peso depreciation as a result of using our own currency to build schools? Certainly not. But if this were the case, the groups advocating that we need a significant depreciation of the currency should jump for joy.
Primary dealers can later offer T-bills to households and firms in the secondary market. These also purchase them gladly. For us in the private sector, it is wealth. Yet, most people call this “national debt” and have a negative view of it simply because of the word, debt. In reality, it is just an accounting record of the Treasury bills in the hands of the private sector (its wealth), P17 trillion currently. Those obsessed with the national debt claim it represents over 60% of our GDP. This ratio is irrelevant. One can choose how to call it, debt or wealth, as long as what it is and who owns it is clear.
The average Filipino does not owe about P130,000. This statement is ludicrous. Yet newspapers and commentators repeat it over and over. If anything, the truth is that, on average, each Filipino owns this amount, though in reality the ownership of T-bills is highly concentrated in the financial system and households with high income.
Another important point to highlight is that T-bills are issued as an interest rate maintenance operation, not government borrowing, as is most often understood. It is intriguing to hear bankers complain about the fiscal deficit. Bond (debt) issuance brings stability to our financial system, and a large portion is in the asset side of our banks’ balance sheets.
It is important to differentiate between debt in pesos and debt in a foreign currency. The Philippine government will always pay peso-denominated debt simply because it will always have pesos to honor it. This represents about 70% of the total national debt. The other 30% is foreign-denominated. This is the potentially problematic one because the government has to make sure it has the foreign currency to pay it. This is not a large share, and, so far, the government has been able to honor it.
There might be good reasons why the Philippine government sometimes borrows dollars, for example to purchase defense equipment. What is less clear is when the government claims that foreign borrowings are for budgetary support, if this means for items in the national budget such as education, civil servants’ salaries, and the like, denominated in pesos.
For those obsessed with the debt-to-GDP ratio, they should follow just foreign-currency denominated debt. Moreover, while economists have spilled uncountable volumes of ink worrying about government debt, there is no particular “debt ratio” that even their most sophisticated theories say governments should target — while the most popular empirical studies were later debunked for having simple Excel errors.
No economy has entered into a crisis as a consequence of running fiscal deficits and issuing debt — such as Treasury bills — denominated in its own currency. The rating agencies and international institutions unnecessarily raise a red flag when the ratio of public debt-to-GDP increases. The debt that matters is that of the private sector and that in a foreign currency. If the world economy collapses, as some predict, it will be the result of private sector debt, not public.
Related to the above, a perennial complaint is that interest payments on debt represent a significant portion of the national budget. These pesos, some claim, could be used more productively. This complaint shows significant lack of understanding.
Follow this example: the government spends, say, P1,000 on infrastructure (a payment that goes to a company in the private sector) and collects only P500 in taxes. The difference is the fiscal deficit. Second, Treasury and the BSP offer the private sector (through the primary dealers) a great deal: the excess P500 — money that entered the economy through government spending — is swapped for a piece of paper called a Treasury bill, which is willingly purchased because the sovereign Treasury of the Philippines is expected to repay (zero default risk unless this is a political decision) the principal P500 with interest of, say, P25. How does Treasury pay interests on debt?
The same way as any other payment: through the BSP by creating new money. Apart from the fact that the government paid a company to build infrastructure (corruption has nothing to do with what we are explaining here), the operation provides the private sector with additional funds in the form of interest, additional disposable income. Businesspeople seem to complain about the fact that interest payments on debt are income that goes to their pockets. We rest our case.
(To be continued.)
Jesus Felipe is a distinguished professor and research fellow at the Carlos L. Tiu School of Economics, De La Salle University. Mariel MonicA Sauler is an associate professor and chair of the Carlos L. Tiu School of Economics, De La Salle University. The authors are grateful to Eunice Gerenia, economics student, De La Salle University, for her excellent research assistance.