Options for Europe – Part 65

The title is my current working title for a book I am finalising over the next few months on the Eurozone. If all goes well (and it should) it will be published in both Italian and English by very well-known publishers. The publication date for the Italian edition is tentatively late April to early May 2014.

You can access the entire sequence of blogs in this series through the – Euro book Category.

I cannot guarantee the sequence of daily additions will make sense overall because at times I will go back and fill in bits (that I needed library access or whatever for). But you should be able to pick up the thread over time although the full edited version will only be available in the final book (obviously).

Part III – Options for Europe

[I AM NOW WORKING ON PART III – THE LAST PART – WHICH WILL COMPRISE NINE CHAPTERS INCLUDING A VERY BRIEF INTRODUCTION AND CONCLUSION. THE CHAPTER ORDER WILL BE SOMETHING LIKE THIS:

Chapter 17 Introduction as before
Chapter 18 MMT and Functional Finance
Chapter 19 Job Guarantee
Chapter 20 MMT and Framing
Chapter 21 Current Orthodoxy – Austerity
Chapter 22 Fiscal Federation – Hybrid debt plans etc
Chapter 23 Overt Monetary Financing
Chapter 24 Abandon Euro – Costs, threats and opportunities
Chapter 25 Conclusion

SO CHAPTERS 21 and 22 CONSIDER OPTIONS WHILE RETAINING THE UNION, CHAPTER 23 WOULD ALLOW THE UNION TO BE RETAINED BUT IS ALSO MORE GENERAL, CHAPTER 24 ABANDONS IT – I AM ON SCHEDULE TO FINISH BY THE END OF THIS MONTH]

[THIS NEXT SECTION IS PART OF CHAPTER 18, WHICH DETAILS THE OPTIONS FACING A CURRENCY ISSUING GOVERNMENT AS DETAILED IN MMT – THIS IS DEVELOPED AS THE BENCHMARK FOR CONSIDERING THE REST OF THE DISCUSSION. THE RATIONALE IS THAT A LOT OF OPTIONS ARE SUPPRESSED OR NOT EVEN CONSIDERED BECAUSE PEOPLE ARE UNAWARE OF HOW MONETARY SYSTEMS CAN WORK UNDER DIFFERENCE INSTITUTIONAL ARRANGEMENTS. THAT IS, WHAT DOES A NATION GAIN WHEN IT ISSUES ITS OWN CURRENCY AND WHAT IS LOST WHEN IT DOESN’T. THE SECTION BELOW WILL FOLLOW A STATEMENT OF MMT PRINCIPLES FOR THE LAYPERSON AS A REFERENCE FRAMEWORK FOR ASSESSING THE OPTIONS. I WON’T POST THE EARLIER PARTS (THEY HAVE BEEN WRITTEN). THE SECTION THAT FOLLOWS COMPLETES THAT CHAPTER AND SETS UP THE CHAPTER THAT COMES LATER ON OVERT MONETARY FINANCING AS A VIABLE OPTION]

The basic principles of Functional Finance

The fundamentals of MMT are derived, in part, from the work of economist Abba Lerner, who emphasised that the conduct and evaluation of economic policy should be intrinsically linked to the aim of advancing social purpose. As in Figure 10.2, economic policy cannot be assessed without regard to the functions it serves. Trying to assess whether the economic policy settings are ‘good’ or ‘bad’ in terms of whether the fiscal deficit is below or above 3 per cent of GDP is thus a deeply flawed approach.

In 1943, Abba Lerner published a 14-page article entitled – Functional Finance and the Federal Debt, which sought to provide a roadmap for governments aiming to eliminate “economic insecurity” (Lerner, 1943: 38). It was written in the final years of the Second World War and Lerner was worried about the “threat to democratic civilisation” (p. 38) posed by fascism and how nations might resist falling prey to extremist ideologies, especially when it is clear that extreme political positions emerge when there is hardship and mass unemployment.

An essential aim of Lerner’s work was to further elucidate the “principles by which appropriate government action can maintain prosperity” (p 38). These principles had emerged from the work of John Maynard Keynes and others during the Great Depression and demonstrated the poverty of the so-called ‘classical’ ideas that had dominated the period prior to the 1930s. The ‘classical’ approach extolled the virtues of the free market and fiscal austerity and underpins the modern neo-liberal way of thinking. Keynes and others demonstrated, beyond doubt that these principles not only were flawed from a theoretical perspective but also failed the evidence test. They simply didn’t describe the way the world worked and the policies that were derived from the flawed theories often made matters worse. It should not escape you that this orthodoxy that Keynes and others convincingly debunked during the Great Depression is the same neo-liberal orthodoxy that dominates today. For many decades following the Great Depression, however, the ‘classical ideas were not considered to be credible or worthy of any status.

Abba Lerner noted that (p. 38):

Many of our publicly minded men who have come to see that deficit spending actually works still oppose the permanent maintenance of prosperity because in their failure to see how it works they are easily frightened by fairly tales of terrible consequences.

The sense of fright is driven by ignorance and a failure to comprehend how a system operates. Neo-liberals magnify that sense of fright, by demonising what are otherwise sensible and viable explanations of economic matters. They know that elevating these ideas into the domain of taboo, that they increase the probability that political acceptance of the ideas will not be forthcoming. That strategy advances the ideological agenda. The basic rules that should guide government fiscal policy are, as Lerner noted, “extremely simple” and “it is this simplicity which makes the public suspect it as too slick” (p. 29). That suspicion is manipulated by those who have vested (ideological) interests in ensuring that there is not a widespread comprehension of the theory and its benefits, which would lead to its popular acceptance.

In an earlier article, The Economic Steering Wheel: the Story of the People’s New Clothes (Lerner, 1941), which was later reproduced with minor editorial changes as Chapter 1 in his 1951 book – The Economics of Employment (Lerner, 1951), Lerner introduced the famous ‘steering wheel’ metaphor. Figure 10.2 is based in the notion that we should see the economy as a vehicle we can control to achieve our collective well-being. This is in contrast to the neo-liberal concept of the economy as a self-regulating mechanism, which demands us to act as sacrificial lambs to maintain its ‘health’. In the same way, the ‘steering wheel’ metaphor is used by Lerner to juxtapose the laissez-faire approach where the car zig-zags across the road, often out of control and producing multiple wrecks, with the alternative, where judicious use of the steering wheel can ensure the car travels safely and smoothly along the road. Lerner considered fiscal and monetary policy to be ways in which government can ‘steer’ the economy to avoid the crises that the free market approach creates (for example, the Great Depression then, and the GFC now).

In relating the metaphor to the economy, Lerner (1951: 4-5) noted that in the main, people accept the need to use the steering wheel for orderly driving:

But are they as reasonable about other things as they are about the desirability of steering their automobiles? … Do they not allow their economic automobiles to bounce from depression to inflation in wide and uncontrolled arcs? Through their failure to steer away from unemployment and idle factories are they not just as guilty of public injury and insecurity as the mad motorists …

Abba Lerner distinguished between what he called Functional Finance and Sound finance, the latter being the orthodoxy he confronted (which is consistent with the vision shown in Figure 10.1). ‘Sound finance’, which also dominates the public debate in the current period is usually expressed in terms of some defined fiscal and monetary policy rules – for example, governments should aim for a fiscal balance or the central bank should only allow the money supply to increase in line with the rate of real output growth. These rules, which are rarely challenged, usually disguise an underlying conservative morality about the role of government (for example, deficits are characterised as ‘living beyond the means’ etc). The SGP rules, which are also now taken as given, exemplify the idea of Sound Finance.

By way of departure, Lerner considered a government should always use its policy capacity to achieve full employment and price stability and thought that fiscal or monetary policy rules based on conservative morality were not likely to help in that regard. In contrast to ‘Sound finance’, Lerner said that (1943: 39-40):

The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound and what is unsound … The principle of judging fiscal measures by the way they work or function in the economy we may call Functional Finance.

The first responsibility of the government (since nobody else can undertake the responsibility) is to keep the total rate of spending in the country on goods and services neither greater nor less than that rate which at the current prices would buy all the goods that it is possible to produce. If total spending is allowed to go above this there will be inflation, and if it is allowed to go below this there will be unemployment. The government can increase total spending by spending more itself or by reducing taxes so that taxpayers have more money left to spend. The government can increase total spending by spending more itself or by reducing taxes so that the taxpayers have more money left to spend. It can reduce total spending by spending less itself or by raising taxes so that taxpayers have less money left to spend. By these means total spending can be kept at the required level, where it will be enough to buy the goods that can be produced by all who want to work, and yet not enough to bring inflation by demanding (at current prices) more than can be produced. [emphasis in original]

This statement of purpose – Lerner’s ‘first law of Functional Finance’ – recognises the basic rule of macroeconomics – that spending equals income and output, which drives the demand for labour. Unemployment results from insufficient spending – it is a macroeconomic problem. The neo-liberal claims that unemployment arises because, for various reasons, individuals do not seek work hard enough, totally misses the point. An individual cannot search for jobs that are not there!

In other words, the government responsibility should be to adjust its spending and taxation to ensure that all production is purchased and that this level of production generates jobs for all, such that the society cannot produce any more goods and services with its current available inputs. What are the financial implications of this? Lerner noted that if in fulfilling its responsibilities, the government records a fiscal deficit, then it “would have to provide the difference by borrowing or printing money. In neither case should the government feel that there is anything especially good or bad about this result” (p. 40). The goal is to “concentrate on keeping the total rate of spending neither too small nor too great, in this way preventing both unemployment and inflation” (p. 40). Importantly, assessments of ‘good’ or ‘bad’ are defined purely in terms of whether the government is achieving its goals. Obviously, moral considerations enter at the stage of setting goals. It is clearly a values-based position to aim for a state where everyone can find work who desires to do so. Once agreed that this will be the societal goal, then we should be indifferent, if in different circumstances (for example, the strength of private sector spending), a deficit of 1 per cent of GDP or a deficit of 5 per cent of GDP is required to meet that goal. Thinking in this way flushes out where the ideology lies. The neo-liberals obscure their disregard for mass unemployment by claiming that the 5 per cent deficit is dangerous and unsustainable. If the public truly understood that the 5 per cent deficit is as sustainable as the 1 per cent deficit, then the neo-liberals would be forced to debate their preference for mass unemployment. Clearly, the public would not generally accept that ideological preference and that is why the neo-liberals have to obfuscate their true motivations and hide behind the financial myths concerning the sustainability of government deficits.

Thus, these simple ideas represent a very powerful organising framework for the conduct of government policy, which appear to be totally alien to the type of considerations and priorities that drive the policy-making process in the EMU. The message is that governments should act to advance welfare and, at a minimum, that requires it achieve and sustain full employment; that it has an array of policy tools available to pursue that goal (spending, taxation, debt-issuance, money creation); and that the mix of tools used should be appraised in terms of how effective they are in advancing the mission of the government. No tool is taboo. The use of each depends on what the government is trying to achieve on our behalf and the circumstances in which it finds itself at any point in time.

Economic policy making is about means to ends – a functional endeavour. The goals need to be specified and the tools necessary to achieve those goals utilised. Economic policy making or practice is not a sacred, religious activity where abstract concepts of virtue and sacrifice rule behaviour and choice.

Think about the Stability and Growth Pact “as a rule-based framework for the coordination of national fiscal policies in the European Union” (European Commission, 20xxxxx) in relation to these simple ideas. Within Functional Finance there is no meaning that can be applied to rules such as – “the deficit must not exceed 3% of GDP” – without reference to the functional outcome that the deficit is associated with.

In this regard, Lerner proceeded to debunked the myths of ‘Sound finance’ with respect to the roles that taxation, the issuance of public debt, and ‘money printing’ operations conducted by the central bank play in relation to government spending and deficits. Earlier in the chapter we saw how students of macroeconomics are misled from the outset of their studies into believing that currency-issuing governments are subject to the same financial constraints on their spending as households are. Lerner understood that intrinsically that such an analogy was inapplicable. He noted that “taxing is never never to be undertaken merely because the government needs to make money payments” (p. 40). As we learned earlier, a currency-issuing government does not need to raise revenue in order to spend. This, of-course, throws the role of taxation into question given we intuitively believe we are ‘taxpayers’ giving the government money which it can then spend. From the insights provided by MMT, we now know that spending has to precede taxation because it is the government’s money that we give back to them.

In the spirit of Functional Finance, Lerner only was concerned with the “effects” of taxation, which are twofold: “the taxpayer has less money left to spend and the government has more money” (p. 40). While true, he then observes that the “second effect can be brought about so much more easily by printing the money” (p. 40), which means we only should think of taxation inasmuch as it reduces the capacity of the private sector to spend and should “be imposed only when it is desirable that the taxpayers shall have less money to spend” (p. 40).

The ‘second law of Functional Finance’ relates to the issuance of debt by governments. MMT explains that such practices have not role to play in ‘funding’ government spending and, instead, may facilitate monetary operations (for example, interest rate management by the central bank), although, even then, they are unnecessary artifacts left over from the old gold standard monetary systems. Lerner said the the “government should borrow money only if it is desirable the the public should have less money and more government bonds, for these are the effects of government borrowing” (p. 40). His explanation is consistent with the discussion earlier in the chapter about how central banks might sell government bonds to drain away excess bank reserves to prevent interbank competition from driving the interest rate below the chosen policy interest rate.

The upshot of this discussion is that if there is a deficit and the logic according to the second law predicates against matching this government deficit with bond sales, then the excess “must be met by printing new money” (p. 41). Contrast this insight with the rigidity that was expressed in Article 123 of the Treaty on the Functioning of the European Union which says:

Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.

This is the ‘monetisation of fiscal deficits is banned’ stipulation in the Treaty. The use of the term ‘prohibited’ immediately intends to cast such behaviour as taboo. But in Functional Finance, a government has available all the policy tools that their status as the issuer of the currency bestows on it, including, as Lerner would have it, ‘printing money’. The choice of which tools to use and in what proportion depends on the objectives and the circumstances the government finds itself in.

As a note, the term ‘printing money’ is not used in Modern Monetary Theory (MMT) because it invokes irrational emotional responses about hyperinflation – for example, the term Weimar Republic or Zimbabwe immediately enters the conversation and reasoned debate then becomes impossible. Moreover, and more importantly, the term is not a satisfactory description of what actually happens when the central bank ‘credits’ (to create an accounting record relating to spending) or ‘debits’ (to create an accounting record relating to the receipt of revenue) bank accounts on behalf of the treasury arm of government that it serves. We don’t need to get into too much detail in this book about this accounting jargon (‘debits’ and ‘credits’). Suffice to say that the electronic records that describe the relationship between the treasury arm of government, the central bank and the private banking system, use the conventions of the accounting profession. To maintain an accounting record of government spending plans, the treasury would ask the central bank to put some numbers equal to those dollar spending plans into the accounts to signify that a payment can be made to some recipient of the spending. The numbers entered would just tell the treasury what funds the private sector could draw upon as public outlays. Similarly, when the tax department received revenue it would ask the central bank to record the receipts and the private banking sector would reduce the funds available in the bank account of the tax payer. No printing presses are involved. Keystroke operators are just type numbers into electronic accounting systems in the banking system to signify how much the government wishes to spend and/or how much it has received. It is a very orderly process and goes on hour-by-hour, day-by-day, year-by-year. All government spending is enacted in this way.

Lerner was keenly aware that this option was considered taboo my the conservative economists. He referred to the “almost instinctive revulsion that we have to the idea of printing money, and the tendency to identify it with inflation, can be overcome if we calm ourselves and take not that this printing does not affect the amount of money spent” (p. 41). Another way of thinking about this is the only reason the government would increase its deficit would be to fill a widening shortfall between the total spending required to maintain full employment and current private spending. As we saw earlier in the chapter, this will not be inflationary if the sales boost allows firms to maintain their current levels of production and eliminate unsold inventory. If governments expanded the deficits beyond that point then inflation would threaten. But the inflation risk lies in the spending level not whether it matches its deficit with debt issuance or new money. If the non-government sector, upon receipt of this new money, decided to reduce its current saving rate and to spend more, then the deficit would have to be lower to avoid higher inflation. Equally, holders of government bonds could decide to liquidate their stocks and spend more. In the same way as before, this would require a lower deficit. The choice of debt-issuance or new money creation is separate to the desire to avoid a surge in inflation.

Once we understand these principles then it is easy to understand why Lerner wrote (p. 41):

In brief, Functional Finance rejects completely the traditional doctrines of ‘sound finance’ and the principle of trying to balance the budget over a solar year or any other arbitrary period.

Abba Lerner’s work also contains a very clear message for progressive thinkers who are reluctant in the current debate to think outside of the confines that the neo-liberals have created. For example, the Labour politicians in the United Kingdom confront the austerity debate with claims that they would ‘fix the budget’ over a longer time period to avoid the massive damage that immediate austerity brings. Of-course, even debating the ‘health’ of the fiscal position in terms of some financial ratios is ceding ground to the conservatives – ground that is illegitimate. Lerner (1951: 15) called progressives who argued in this way “proponents of organized prosperity” and said:

A kind of timidity makes them shrink from saying anything that might shock the respectable upholders of traditional doctrine and tempts them to disguise the new doctrine so that it might be easily mistaken for the old. This does not help much, for they are soon found out, and it hinders them because, in endeavoring to make the new doctrine appear harmless in the eyes of the upholders of tradition, they often damage their case. Thus instead of saying that the size of the national debt is of no great concern … [and] … that the budget may have to be unbalanced and that this is insignificant when compared with the attainment of prosperity, it is proposed to disguise an unbalanced budget (and therefore the size of the national debt) by having an elaborate system of annual, cyclical, capital, and other special budgets.

Progressives should first and foremost seek to educate the public about how the system actually operates and what opportunities the government has to act on our behalf to advance our well-being. In this way, what are cast now as ‘radical’ or ‘taboo’ ideas will start to appear reasonable – grounded in reality. The next step is that they become the mainstream orthodoxy. Progressives should avoid petty conversations that lead to statements such as “we will reduce the deficit more slowly than you but we will still reduce it”. Perhaps at a point in time a deficit reduction will be functional. But that will never be the case when there is mass unemployment of the scale that besets Europe at present. A primary purpose of this book is to provide that educational role and to give progressive thinkers a knowledge basis on which to reasonably challenge the neo-liberal orthodoxy.

Of-course, developing comprehension is just the first step. A bold confidence is also required to withstand the vilification that comes with expressing ideas that are contrary to the neo-liberal norms. Lerner (1951: 16) addressed the problem of progressives who present their arguments in a conservative way because the public might not understand the fundamentals of functional finance:

The scholars who understand it hesitate to speak out boldly for fear that the people will not understand. The people, who understand it quite easily, also fear to speak out while they wait for the scholars to speak out first. The difference between our present situation and that of the story is that it is not an emperor but the people who are periodically made to go naked and hungry and insecure and discontented – a ready prey to less timid organizers of discontent for the destruction of civilization. [emphasis in original]

If governments are so free why do they accept fiscal constraints?

When proponents of MMT say that a currency-issuing government is not revenue-constrained an immediate retort is that governments continue to issue debt and have elaborate accounting structures, which require them to have funds in particular accounts before they can spend. It is also noted that many governments prohibit the central bank from directly purchasing government bonds. The debates in recent years in the US about debt ceilings are also used to support the argument that governments appear to be very revenue constrained. In what sense then is the MMT claim applicable?

Under the gold standard that existed in various forms in the past, but which ended once and for all in 1971 when the Bretton Woods system of fixed exchange rates and US dollar convertibility into gold at a fixed price collapsed governments were, indeed, limited in their spending capacity by how much gold the central bank had in store. This was because the outstanding stock of money that the central bank would issue was proportional to its gold reserves and so if governments wanted to spend more it had to reduce the money held by the non-government sector using taxation and/or bond sales. Clearly, the decision to enter this type of monetary system was voluntary, but once the decision had been taken, the government was bound to operate in that manner. Institutional machinery was then established to facilitate the issuing of bonds to the private markets, although central banks could still purchase government debt.

However, once governments started to adopt fiat currency monetary systems in the 1970s these conventions became irrelevant. All the spending caps and debt limits that had some operational significant prior to the adoption of fiat currencies were now meaningless. Intrinsically, these governments were now free of revenue-constraints. They could spend as much as they wanted up to the volume of goods and services available for sale in their currency. The spending constraint shifted from a financial limit to a real limit – there had to be real goods and services available for sale.

The breakdown of the Bretton Woods system and the rise of Monetarism occurred around the same time and there was intense pressure on governments to retain the various behaviours and supporting institutional structures that limited their spending capacity. Governments thus continued to issue debt even though this was no longer financially necessary. They continued to put spending caps on themselves and preach about fiscal discipline. MMT highlights that these rules and the restrictive accounting procedures that have been retained and in many cases made more severe are just voluntary constraints that have been inherited from the gold standard days. In the era of fiat currency systems, the rules have been perpetuated by the mainstream economics ideology to constrain government and to give more latitude for private market activity. The lunacy of that thinking is that the private sector actually does better when there is a strong fiscal involvement in the economy providing first-class public infrastructure and a highly educated and healthy workforce.

The public debt limits that governments accept are a classic example of a voluntary constraint that could be easily legislated out of existence if the public truly understood how the monetary system operated and that time has moved on since 1971 when the convertible currency system collapsed.

The US social security debate is a classic example of how these voluntary restrictions cloud the public understanding of an important issue. The US social security system set up during the Great Depression requires that specially identified payroll taxes be levied to help pay for social security. If there is an excess of revenue raised in any year it goes in to the Social Security Trust Fund, which is the responsibility of the US Treasury. Normally revenue exceeds payouts and the law requires that the surpluses are invested in “special series, non-marketable U.S. Government bonds” (US Social Security Administration, 2014), which mainstream economists claim indicates that the payroll taxes (that is, the Social Security Trust Fund) ‘finance’ US federal government net spending (deficit).

The Trust fund can be supplemented from the US government at any time they like (subject to legislation). The only time this has happened was in 1982 when the accounting assets of the Trust Fund were close to being depleted and the US Congress allowed the Old Age and Survivors Insurance Trust Fund (OASI), which is the largest of the funds to borrow from elsewhere in the federal system (Board of Trustees, 1982). But these ‘Funds’ are just an elaborate accounting labyrinth. The bottom line is that US federal government can always fund its social security obligations and any other nominal obligations that it faces. There is no need for these elaborate arrangements to ‘store up’ spending capacity.

The EMU itself, is a system of voluntary constraints that are reflected in legal statements that can be changed via appropriate legislation. There is nothing irrevocable about the Euro just as the debt ceiling in the US is just a political contrivance expressed in legal processes, which ensures the conservatives can create embarrassing headlines when deficits rise.

Additional references

This list will be progressively compiled.

Board of Trustees (1982) ‘1982 Annual Report’, Board of Trustees, Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds.

Lerner, A.P. (1941) ‘The Economic Steering Wheel: the Story of the People’s New Clothes’, University Review, University of Kansas, 7 (4), 257-65.

Lerner, A.P. (1943) ‘Functional Finance and the Federal Debt’, Social Research, 10(1), 38-51.

Lerner, A.P. (1951) Economics of Employment, New York, McGraw Hill.

US Social Security Administration (2014) ‘Compilation of the Social Security Laws, Volume I’.

(c) Copyright 2014 Bill Mitchell. All Rights Reserved.