Critics of the Bank of Canada have been out in full force as of late, arguing that through Bank of Canada purchases of Government of Canada bonds, the BoC has effectively been funding government spending with freshly printed money. In other words, as the argument goes, rather than borrowing money from the private sector by issuing bonds, the government simply turns to the BoC to create money “out of thin air” and purchase these bonds directly in the primary market. Because the BoC ultimately remits all of its profits to the GoC, critics point out that bond interest paid by the GoC to the Bank of Canada is eventually returned to the government, effectively rendering the BoC’s loan to the government interest-free.
Of course, the insinuation behind all of this is that the Government of Canada has embarked on a dangerous path towards abandoning any semblance of fiscal discipline. After all, interest-free money is sure to remove the shackles of fiscal restraint, since borrowing at zero-percent interest effectively adds zero additional burden to vote-casting taxpayers. But how realistic is this claim? Before we consider the Bank of Canada’s relationship with the government specifically, it’s helpful to first look at the lending operations of a run-of-the-mill private sector commercial bank. Of course, the Bank of Canada obviously isn’t just another private sector bank, but it does share many similarities with private banking that can help create a framework for better understanding the context of this argument.
Private banks lend money to borrowers all the time – this is their bread and butter. But they don’t do so following the loanable funds model that many people today have come to understand. In other words, banks don’t take deposits from savers and loan these existing funds out to borrowers. Rather, when Paul comes to Bank A seeking a loan for, say, $100, Bank A simply creates money out of thin air by adding a $100 deposit to Paul’s bank account at Bank A. The deposit is obviously Paul’s asset, but it is also Bank A’s liability because Bank A now owes Paul $100 the moment that Paul withdraws the funds. At the same time, the loan results in a $100 asset for Bank A, which is the money Paul now owes Bank A and must pay interest on. And of course, the loan also creates a $100 liability for Paul, since it is money he now owes Bank A at some date far in the future.
Looking at this from the bank’s perspective, if we assume that Bank A were to receive 5% interest on the $100 loan to Paul, then Bank A will receive $5 at the end of the first year. At the same time, if Bank A pay’s 1% on Paul’s newly created deposit, it will pay out $1 at the end of the first year, for a total profit of $4 ($5-$1). From this example, we can easily see how banks earn profits by creating money and lending new money out to credit-worthy borrowers: they profit from the spread between the new financial assets and liabilities that get created as a result of the loan. The profits, of course, are to the sole benefit of Bank A and its shareholders.
Now the private banking system creates money all the time as a matter of normal operations, and in this sense the Bank of Canada is no different. Most people tend to focus their attention on headline-grabbing large scale asset purchases like Quantitative Easing, but in reality, the BoC actually creates money for the government on a fairly regular basis as part of its standard operations. This process stems from the fact that, over time, the Bank of Canada regularly increases the quantity of bank notes (physical paper currency) in the economy to support a growing number of transactions. Understanding this process is useful at illustrating the mechanism by which the BoC “funds” government spending.
The printing of bank notes is, of course, the creation of Bank of Canada liabilities. These are liabilities of the BoC because they’re a promise by the Bank of Canada to pay the holder of bank notes when they submit their paper currency for redemption. Practically speaking, what this means is that as paper currency becomes damaged and worn out over the passage of time, commercial banks return these notes to the Bank of Canada so they can be removed from circulation. In exchange, the Bank of Canada credits the reserve accounts that commercial banks hold at the BoC by an amount equal to the face value of the bank notes removed from circulation.
By the same token, when commercial banks require additional bank notes for distribution among its customers, they acquire new bank notes from the Bank of Canada and pay for those bank notes with money from their reserve accounts held at the BoC. Because the Bank of Canada needs revenue to fund its day-to-day operations, it takes those commercial bank reserves and invests them in perfectly secure assets – Government of Canada bonds. Said another way, the act of printing paper currency into existence has the end effect of increasing both Bank of Canada liabilities (the bank notes) and assets (the government bonds) by an equal and offsetting amount. Similar to how a private commercial bank creates both an asset and liability for itself when it extends a loan, so too does the Bank of Canada create an asset and liability for itself when it extends a loan to the government by purchasing its bonds.
The Bank of Canada, of course, is not a profit-driven institution, although like a private bank, it still earns money on the spread between its assets and liabilities. The revenue it earns from its assets are used to offset its operating costs and the costs of its balance sheet liabilities, with the remainder of the income from its assets making up its profits. Because the Bank of Canada is a crown corporation, any profits are simply returned to the Government of Canada. This, in short, is how the Bank of Canada funds government spending. If new loans made by the Bank of Canada lead to a large spread between the cost of its assets and liabilities, the Bank of Canada contributes much more “funding” to government revenues. If it earns less of a spread, it conversely “funds” government spending in a greatly reduced manner.
The Bank of Canada, obviously, has two ways to increase its profits, which is either increasing the yield from its assets, or decreasing the cost of its liabilities. Understanding assets are simple, but what, precisely, is the cost of its liabilities? In the case of issuing physical currency, the cost of these liabilities on an annual basis is the cost to produce and distribute these bank notes, and the cost to replace them over time. For a $100 bill, for example, the Bank of Canada estimates the total cost of printing the bank note into existence to be 42 cents. If the bank note must be replaced after, say, 10 years, the average cost to create the $100 bill and replace it when it is eventually worn out works out to approximately 4 cents per year (42 cents / 10 years = 4.2 cents). This works out to an annual cost of 0.04% of the face value of the Bank of Canada’s $100 liability. If the Bank of Canada invests its $100 liability into government bonds and earns, say, 2%, it will earn a spread of 1.96%.
In the above example the government will tax its population and collect revenue to pay the interest on the $100 bond owned by the Bank of Canada. The Bank of Canada, in turn, takes the $2 of interest paid by the government, uses 4 cents to pay the cost of production and replacement of the bank note, and returns the $1.96 in profit back to the government. This process is what critics generally refer to when they accuse the Bank of Canada of providing interest free loans to the Government of Canada. Because Bank of Canada loans to the government can potentially generate large spreads and be extremely generous sources of funding for the government, they have the potential to almost completely offset the interest costs of the initial loan.
This, however, isn’t always the case. Bank of Canada loans to the government don’t always result in the creation of low-cost bank notes. When the Bank of Canada engages in large scale loans to the government, as they do by directly purchasing GoC bonds in the primary market or indirectly via purchases in the secondary market (ie. QE), they do so not by creating physical bank notes, but by creating bank reserves. Bank reserves are also called “settlement balances” in Canada, and only exist in reserve accounts that the Government of Canada and commercial banks hold at the Bank of Canada. These are essentially “bank deposits” for banks and the government, serving as assets for the owners of these accounts and liabilities of the Bank of Canada.
Just like all deposits held in the commercial banking system always exist in someone’s bank account at all times, bank reserves are always held in someone’s reserve account at the Bank of Canada at all times. Thus, when the government writes cheques to the private sector, and these cheques are deposited at private commercial banks, the government merely transfers reserves from its account at the BoC to the reserve accounts of private commercial banks. Reserve deposits, once created, are therefore just transferred from one reserve account to another while remaining liabilities of the BoC. The Bank of Canada, of course, pays interest on bank reserves at the “deposit rate”, which, under the current “floor” system, is simply the Bank of Canada’s target for the overnight rate.
Currently the target for the overnight rate in Canada is 0.25%, meaning that when the Bank of Canada creates money for the government using large scale asset purchases, they generate reserve liabilities costing them 0.25%. While 0.25% may not seem like much at first glance, the bonds and treasury bills that the BoC acquires from the government yield little more than that, meaning that the overall spread between the BoC’s assets and liabilities are miniscule. Profits that are made by the BoC and remitted to the government are therefore correspondingly low, meaning that in the current low interest rate environment, the BoC isn’t really providing much “funding” to the government at all.
At the time of this writing, the average yield on government 1-to-3-year bonds is a mere 0.25%. This is the exact same yield as the “deposit rate” that the BoC pays on its reserve liabilities. So when the BoC creates reserves (Bank of Canada liabilities) and loans it to the GoC in exchange for a bond (Bank of Canada assets), this amounts to a spread on the loan of exactly zero. What this means is that the BoC generates zero net return from the transaction and therefore doesn’t send a penny back to the government in the form of remitted profits. At this point it doesn’t really matter whether the government borrowed from either the private sector or the Bank of Canada. If it borrows from the private sector it pays 0.25% on the loan. If it borrows from the BoC, it also pays 0.25% for the loan but, in this particular case, receives no offsetting “funding” from the Bank of Canada.
Of course, the BoC can always purchase higher yielding government bonds and extend its duration in an attempt to increase its spreads. The current 10-year benchmark bond yield is 0.69%, meaning that a loan made to the government for 10 years would net the Bank of Canada 0.44% (0.69% – 0.25%). Thus, if the GoC borrowed for 10 years in the private market, it would have a 0.69% cost of funds, whereas if it borrowed from the BoC, it would have a cost of funds of just 0.25%. So clearly there are conditions where it benefits the government to borrow from the Bank of Canada versus the private sector, but the recent COVID-induced BoC purchases of short-term T-Bills isn’t one of them. These operations resulted in near-zero spreads for the Bank of Canada, meaning that BoC profits from the loans were virtually non-existent. In other words, when it comes to performing large scale asset purchases of short-term government debt in the current interest rate environment, cries of the BoC surreptitiously providing “free money” for the government are as far from the mark as they could possibly be.