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Options for Europe – Part 70

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


Chapter 18 A monetary framework for fiscal policy activism

The debate about what options are available to Europe at present is significantly restricted by the lack of awareness of a viable alternative monetary system. The chapter seeks to restate the rudiments of macroeconomics to present a generalised theoretical framework, which demonstrates the actual options and responsibilities that apply to modern governments that issue a fiat currency. The monetary framework developed provides a coherent basis for fiscal activism and provides a real alternative to the austerity and stagnation that besets the Eurozone at present. The principles developed both provide insights for reform within the existing common currency arrangement and a basis for understanding the consequences of breaking up the monetary union and restoring individual currencies. The chapter draws heavily from Mitchell and Muysken (2008).

This monetary framework is presented as a direct challenge to the orthodox macroeconomic consensus that dominates the Eurozone debate, which has provided the so-called intellectual authority to policy makers, intent on pursuing fiscal austerity even though the legacy of such policies has been mass unemployment, increasing poverty and economic stagnation. The chapter demonstrates that the austerity consensus is not grounded in any logical understanding of the modern monetary system and deliberately ignores many of the actual options that are available to fiat-currency issuing governments.
Students of macroeconomics are misled very early in their studies. The mainstream macroeconomics textbooks start with the flawed analogy between the household and the sovereign government, which claims that the government’s ‘budget’ is governed by the same principles that constrain the household. Application of this analogy leads to false conclusions. The reality is that fiscal surpluses do not give governments a greater capacity to meet future needs, and fiscal deficits do not erode that capacity. Governments, which issue their own currency, always have the capacity to spend in their own currencies. Currency-issuing governments such as those of Australia, Britain, Japan and the US can never run out of money. In the context of the EMU, currency issuance and fiscal responsibility are dislocated. The European Central Bank is the ‘currency issuer’, given that the Member States ceded that capacity to it upon adopting the Euro as their (foreign) currency but retained fiscal responsibility. The complications that this dislocation engenders are dealt with later in the chapter. But it remains true that the ECB can never run out of Euros nor go broke if it has significant quantities of non-performing debt.

Most people are unaware that a major historical event occurred in 1971, when President Nixon abandoned what had been called the gold standard (or US-dollar standard). Under that monetary system, which had endured for about 80 years (with breaks for war), currencies were convertible into gold, exchange rates were fixed and governments could expand their spending only by increasing taxes or borrowing from the private sector. After 1971, most governments issued their own currencies by legislative fiat; the currencies were not convertible into anything of value, and were floated and traded freely in foreign currency markets. The flexible exchange rate releases monetary policy from defending some fixed parity; fiscal policy can then target only the domestic spending gap to maintain high levels of employment.

Most nations have operated ‘fiat monetary systems’ since 1971; as a result, national governments no longer have to ‘fund’ their spending. The level of liquidity in the system is not limited by gold stocks, or by anything else. Most of the analysis appearing in macroeconomics textbooks, which permeates into the public debate, is derived from ‘gold standard’ logic and does not apply to modern monetary systems. Economic policy ideas that dominate the current debate are artifacts from the old system, and do not apply to fiat monetary systems.

Modern monetary economies use fiat currencies

The starting point is to understand the central role that government can play in a modern monetary economy. Modern monetary economies use money as the unit of account to pay for goods and services. An important notion is that money is a fiat currency, that is, it is convertible only into itself and not legally convertible by government into gold, for instance, as it was under the gold standard. The monetary unit (currency) has no intrinsic worth. The viability of the currency is guaranteed, because it is the only unit acceptable for payment of taxes and other financial demands of the government. The private sector has to get hold of the currency to meet its tax obligations, which requires the government to ‘spend the currency into existence’. In most nations, the currency issuer is at the same time the agency responsible for fiscal policy (spending and taxation).

Figure 18.1 shows the essential structural relations between the government and non-government sectors. First, despite claims that central banks are largely independent of government, there is no real significance in separating treasury and central bank operations. The consolidated government sector determines the extent of the net financial assets position (denominated in the currency of issue) in the economy. For example, while the treasury operations may deliver surpluses (destruction of net financial assets) this could be countered by a deficit (of say equal magnitude) as a result of central bank operations. This particular combination would leave a neutral net financial position.

While the above is true, most central bank operations merely shift non-government financial assets between bank reserves and government bonds, so for all practical purposes the central bank is not involved in altering net financial assets. The exceptions include the central bank purchasing and selling foreign exchange and paying its own operating expenses.

The relationship between the government and non-government sectors is referred to as a ‘vertical’ relationship signifying that transactions between these sectors add or subtract from the financial assets held within the non-government sector. This is in contradistinction with transactions within the non-government sector, which alter who owns the financial assets but do alter the net position of that sector overall. For example, when a bank creates a loan, the recipient has a new asset (the deposit) but simultaneously has an equal new liability (the loan). While within-government transactions occur, they are of no importance to understanding the vertical relationship between the consolidated government sector (treasury and central bank) and the non-government sector. That point is explained in a later section. Second, extending the model to distinguish the foreign sector makes no fundamental difference to the analysis and as such the private domestic and foreign sectors can be consolidated into the non-government sector without loss of analytical insight. Foreign transactions are largely distributional in nature, which means they alter the ownership of assets and liabilities between the nation and the rest of the world.

Figure 18.1 The essential government and non-government structure

In Figure 18.1, net financial assets enter and exit the economy as a result of so-called ‘vertical’ transactions between the government and non-government sectors. What are these vertical transactions between the government and non-government sectors and what is the importance of them for understanding how the economy works?

Mosler and Forstater (1998) said that:

The tax liability lies at the bottom of the vertical, exogenous, component of the currency. At the top is the State (here presented as a consolidated Treasury and Central Bank), which is effectively the sole issuer of units of its currency, as it controls the issue of currency units by any of its designated agents. The middle section of the graph is occupied by the private (non-government) sector. It exchanges goods and services for the currency units of the state, pays taxes, and accumulates what is left over (State deficit spending) in the form of cash in circulation, reserves (clearing balances at the State’s Central Bank), or Treasury securities (deposits; offered by the CB) … The currency units used for the payment of taxes (or any other currency units transferred to the State), for this analysis, is considered to be consumed (destroyed) in the process. As the State can issue paper currency units or accounting information at the CB at will, tax payments need not be considered a reflux back to the state for the process to continue.

The two arms of government (treasury and central bank) have an impact on the stock of accumulated financial assets in the non-government sector and the composition of the assets. The government deficit (treasury operation) determines the cumulative stock of financial assets in the private sector. Central bank decisions then determine the composition of this stock in terms of notes and coins (cash), bank reserves (clearing balances) and government bonds.

Taxes are schematically shown going to the rubbish bin, which emphasises that they do not finance anything. While taxes reduce balances in private sector bank accounts, the government doesn’t actually get anything – the reductions are accounted in the ‘books’ for but go nowhere. Thus the concept of a fiat-issuing government saving in its own currency is of no relevance. Governments may use its net spending to purchase stored assets (for example, Norway’s sovereign fund) but that is not the same as saying when governments run surpluses (taxes in excess of spending) the funds are stored and can be spent in the future. This concept is erroneous. Finally, payments for bond sales are also accounted for as a drain on liquidity but then also scrapped.

Government deficit (surplus) exactly equals non-government surplus (deficit)

As a matter of accounting between the sectors, a government fiscal deficit, where treasury spending exceeds taxation revenue, adds net financial assets (adding to non-government savings) available to the private sector and a fiscal surplus, where treasury spending is less than taxation revenue, has the opposite effect. The last point requires further explanation, as it is crucial to understanding the basis of modern money macroeconomics.

A simple example helps reinforce this basic point. Suppose two people populate the economy, one being government and the other deemed to be the private (non-government) sector (see Nugent, 2003). If the government runs a balanced fiscal position (spends 100 dollars and taxes 100 dollars) then private accumulation of fiat currency (savings) is zero in that period and the private budget is also balanced. Say the government spends 120 and taxes remain at 100, then the private surplus is 20 dollars, which can accumulate as financial assets and represents an increase in the private sector’s net worth. The corresponding 20 dollar notes have been issued by the government to cover its additional expenses. The private saving of $20 initially takes the form of non-interest bearing deposits. The government may decide to issue an interest-bearing bond to encourage saving but operationally it does not have to do this to finance its deficit. The government deficit of 20 is exactly the private savings of 20. Now if government continued in this vein, accumulated private savings would equal the cumulative fiscal deficits. However, should government decide to run a surplus (say spend 80 and tax 100) then the private sector would owe the government a net tax payment of 20 dollars and would need to run down its prior savings or sell interest-bearing bonds back to the government to get the needed funds. The result is the government generally buys back some bonds it had previously sold.

Either way accumulated private saving is reduced dollar-for-dollar when there is a government surplus. The government surplus has two negative effects for the private sector: (a) the stock of financial assets (money or bonds) held by the private sector, which represents its wealth, falls; and (b) private disposable income also falls in line with the net taxation impost. Some may retort that government bond purchases provide the private wealth-holder with cash. That is true but the liquidation of wealth is driven by the shortage of cash in the private sector arising from tax demands exceeding income. The cash from the bond sales pays the Government’s net tax bill. The result is exactly the same when expanding this example by allowing for private income generation and a banking sector.

From the example above, and further recognising that currency plus bank reserves (the monetary base) plus outstanding government securities constitutes net financial assets of the non-government sector, the fact that the non-government sector is dependent on the government to provide funds for both its desired net savings and payment of taxes to the government becomes a matter of accounting. Government is the only entity that can provide the non-government sector with net financial assets (net savings) and thereby simultaneously accommodate any net desire to save (financial assets) and thus eliminate unemployment. It does this by net spending – that is, by running fiscal deficits. Additionally, and contrary to mainstream rhetoric, yet ironically, necessarily consistent with national income accounting, the systematic pursuit of government budget surpluses is dollar-for-dollar manifested as declines in non-government savings. If the aim was to boost the savings of the private domestic sector, when net exports are in deficit, then as Wray (1998: 81) suggested ‘taxes in aggregate will have to be less than total government spending.’ Thus, in general, deficit spending is necessary to ensure high levels of employment.

This framework also allows us to see why the pursuit of government budget surpluses will be contractionary. Pursuing budget surpluses is necessarily equivalent to the pursuit of non-government sector deficits. They are two sides of the same coin. The decreasing levels of net savings financing the government surplus increasingly leverage the private sector and the deteriorating debt to income ratios will eventually see the system succumb to ongoing demand-draining fiscal drag through a slow-down in real activity.

To summarise the macroeconomic principles that emerge from this discussion: Budget surpluses can be achieved only through decreases in non-government savings (increases in non-government debt) and reduce private savings (increase private debt). Moreover, budget surpluses do not add to government wealth or their ability to spend. Finally, budget surpluses have an inherent tendency to reduce aggregate demand.

How do deficits arise? How does a government spend?

Governments typically have cash operating accounts with the central bank from which they spend on a daily basis and receive daily receipts (tax revenue). When the government spends, the central bank debits these accounts (takes money out) and credits (puts money into) various bank accounts within the commercial banking system. Deposits thus show up in a number of commercial banks as a reflection of the government spending. It may issue a cheque and post it to someone in the private sector whereupon that person will deposit the cheque at his or her bank. It is the same effect as if it had have all been done electronically.

You will note that:

  • Governments do not spend by “printing money”. They spend by creating deposits in the private banking system. Clearly, some currency is in circulation which is ‘printed’ but that is a separate process from the daily spending and taxing flows;
  • There has been no mention of where the government gets the ‘credits’ and ‘debits’ from! Central banks create bank reserves (money) out of thin air; and
  • Any coincident issuing of government debt (bonds) has nothing to do with ‘financing’ the government spending – a point that is explained further on in this chapter.

All the commercial banks maintain reserve accounts with the central bank, which permit reserves to be managed and also allow the cheque clearing system to operate smoothly. These accounts typically have to have positive balances at the end of each day, although during the day a particular bank might be in surplus or deficit, depending on the pattern of the cash inflows and outflows. There is no reason to assume that these flows will exactly offset themselves for any particular bank at any particular time. When the government spends, increased deposits (credits) appear in the accounts of the commercial banks (whether directly or indirectly as cheques are posted and deposited). This in turn means that bank reserves rise. Thus government spending adds to reserves that the private bank holds at the central bank.

Taxation works exactly in reverse. Private bank accounts are debited (and private reserves fall) and the government accounts are credited and their reserves rise. All this is accomplished by accounting entries only. The taxation does not go anywhere! It is not stored anywhere and certainly does not ‘finance’ the spending. The non-government sector cannot pay its taxes until the government has spent! It is a good practice to think of taxes as just draining liquidity from the non-government sector reflecting the Government’s desire for that sector to have less spending capacity.

Government spending is not inherently revenue constrained

Spending by private citizens is constrained by the sources of available funds, including income from all sources, asset sales and borrowings from external parties. National government spending, however, is largely facilitated by the government issuing cheques drawn on the central bank. The arrangements the government has with its central bank to account for this are largely irrelevant. When the recipients of the cheques (sellers of goods and services to the government) deposit the cheques in their bank, the cheques clear through the central banks clearing balances (reserves), and credit entries appear in accounts throughout the commercial banking system. In other words, government spends simply by crediting a private sector bank account at the central bank. Operationally, this process is independent of any prior revenue, including taxing and borrowing. Nor does the account crediting in any way reduce or otherwise diminish any government asset or government’s ability to further spend.
Alternatively, when taxation is paid by private sector cheques (or bank transfers) that are drawn on private accounts in the member banks, the central bank debits a private sector bank account. No real resources are transferred to government. Nor is government’s ability to spend augmented by the debiting of private bank accounts.

In general, mainstream economics errs by blurring the differences between private household budgets and the government fiscal position. For example, Barro (1993: 367) said that ‘we can think of the government’s saving and dissaving just as we thought of households’ saving and dissaving.’ This errant analogy is advanced by the popular government budget constraint framework (GBC) that now occupies a chapter in any standard macroeconomics textbook. The GBC is used by orthodox economists to analyse three alleged forms of public finance: (1) Raising taxes; (2) Selling interest-bearing government debt to the private sector (bonds); and (3) Issuing non-interest bearing high powered money (money creation). Various scenarios are constructed to show that either deficits are inflationary if financed by high-powered money (debt monetisation), or squeeze private sector spending if financed by debt issue. While in reality the GBC is just an ex post accounting identity, orthodox economics claims it to be an ex ante financial constraint on government spending.

The GBC leads students to believe that unless the government wants to ‘print money’ and cause inflation it has to raise taxes or sell bonds to get money in order to spend. Bell (2000: 617) said that the erroneous understanding that a student will gain from a typical macroeconomics course is that “the role of taxation and bond sales is to transfer financial resources from households and businesses (as if transferring actual dollar bills or coins) to the government, where they are re-spent (i.e., in some sense ‘used’ to finance government spending).”

What is missing is the recognition that a household, the user of the currency, must finance its spending beforehand, ex ante, whereas government, the issuer of the currency, necessarily must spend first (credit private bank accounts) before it can subsequently debit private accounts, should it so desire. The government is the source of the funds the private sector requires to pay its taxes and to net save (including the need to maintain transaction balances). Clearly the government is always solvent in terms of its own currency of issue.

Standard macro textbooks struggle to explain this to students. Usually, there is some text on so-called money creation but no specific discussion of the accounting that underpins spending, taxation and debt-issuance. Blanchard (1997: 429) is representative and said government

… can also do something that neither you nor I can do. It can, in effect, finance the deficit by creating money. The reason for using the phrase ‘in effect’, is that … governments do not create money; the central bank does. But with the central bank’s cooperation, the government can in effect finance itself by money creation. It can issue bonds and ask the central bank to buy them. The central bank then pays the government with money it creates, and the government in turn uses that money to finance the deficit. This process is called debt monetization.

In Chapter 23, the Overt Monetary Financing (OMF) option, which is often referred to as the government ‘printing money’, will be discussed in detail. Mainstream economists consider this option taboo because they claim, erroneously, that it causes severe inflation.

In summary, it can be concluded from the above analysis that governments spend (introduce net financial assets into the economy) by crediting bank accounts in addition to issuing cheques or tendering cash. Moreover, this spending is not revenue constrained. A currency-issuing government has no financial constraints on its spending, which is not the same thing as acknowledging self imposed (political) constraints.

State money introduces the possibility of unemployment

Once we realise that government spending is not revenue-constrained then we have to analyse the functions of taxation in a different light. The imposition of taxation functions to promote offers from private individuals to government of goods and services in return for the necessary funds to extinguish the tax liabilities. The neo-liberal conception is that taxation provides revenue to the government, which it requires in order to spend. The reality is that the reverse is the truth.

Government spending provides revenue to the non-government sector, which then allows the latter to extinguish its taxation liabilities. So the funds necessary to pay the tax liabilities are provided to the non-government sector by government spending. It follows that the imposition of the taxation liability creates a demand for the government currency in the non-government sector, which allows the government to pursue its economic and social policy program. While real resources are transferred from the non-government sector in the form of goods and services that are purchased by government, the motivation to supply these resources is sourced back to the need to acquire fiat currency to extinguish the tax liabilities. Further, while real resources are transferred, the taxation provides no additional financial capacity to the government of issue. Conceptualising the relationship between the government and non-government sectors in this way makes it clear that it is government spending that provides the paid work, which eliminates the unemployment created by the taxes.

So it is now possible to see why mass unemployment arises. It is the introduction of State Money (which we define as government taxing and spending) into a non-monetary economics that raises the spectre of involuntary unemployment. For all the goods and services produced in any period to be sold, total spending must equal total income (whether actual income generated in production is fully spent or not each period). Involuntary unemployment is idle labour offered for sale with no buyers at current prices (wages). This unemployment thus occurs when the private sector, in aggregate, desires to earn the currency through the offer of labour but doesn’t desire to spend all it earns, other things equal. As a result, involuntary inventory accumulation among sellers of goods and services translates into decreased output and employment. In this situation, nominal (or real) wage cuts per se do not clear the labour market, unless those cuts somehow eliminate the private sector desire to net save, and thereby increase total spending.

Unemployment occurs when net government spending is too low

The purpose of State Money (the currency of the government) is to facilitate the movement of real goods and services from the non-government (largely private) sector to the government (public) domain. Government achieves this transfer by first levying a tax, which creates a notional demand for its currency of issue. To obtain funds needed to pay taxes and net save, non-government agents offer real goods and services for sale in exchange for the needed units of the currency. This includes, of-course, the offer of labour by the unemployed. The obvious conclusion is that unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save. Either government spending is too low relative to the current tax receipts or taxes are too high relative to the level of government spending.

This analysis also sets the limits on government spending. It is clear that government spending has to be sufficient to allow taxes to be paid. In addition, net government spending is required to meet the private desire to save (accumulate net financial assets). From the previous paragraph it is also clear that if the Government doesn’t spend enough to cover taxes and the non-government sector’s desire to save the manifestation of this deficiency will be unemployment. Keynesians have used the term demand-deficient unemployment. In our conception, the basis of this deficiency is at all times inadequate net government spending, given the private spending (saving) decisions in force at any particular time.

For a time, what may appear to be inadequate levels of net government spending can continue without rising unemployment. In these situations, as is evidenced in many countries in the pre-GFC period, GDP growth can be driven by an expansion in private debt. The problem with this strategy is that when the debt service levels reach some threshold percentage of income, the private sector will ‘run out of borrowing capacity’ as incomes limit debt service and banks become risk-adverse. Typically, this will then provoke efforts to reduce the debt exposure (so-called ‘balance sheet restructuring’) and rmake the household and/or firm finances less precarious. As a consequence, total spending from private debt expansion slows and the economy falters. In this case, any fiscal drag (inadequate levels of net government spending) begins to manifest as unemployment.

The point is that for a given tax structure, if people want to work but do not want to continue consuming at the previous rate but want to reduce their debt exposure, then the Government can increase spending and purchase goods and services and full employment is maintained. The alternative is unemployment and a recessed economy. It is difficult to imagine that an increasing deficit will be inflationary in a recessed economy because there are so many underutilised resources, both capital and labour. Indeed, in Chapter 19, we will argue that the first thing a currency-issuing government should do is offer all the idle labour a job and pay them a socially-acceptable minimum wage with all the additional statutory entitlements. By definition, the unemployed have no ‘market price’ because there is no private demand for their labour. Offering to buy a service for which there is no demand (and hence no current ‘price bid’) is not an inflationary act. That issue will be analysed more deeply in Chapter 19 as we develop the options available to nations currently in the Eurozone.

The central bank administers the risk-free interest rate and government debt functions to support it

In most countries the central bank conducts monetary policy by controlling the short-run interest rate, which then sets the benchmark for the longer-term commercial interest rates, such as homemortgages. The so-called central bank ‘operations’ aim to manage the liquidity in the banking system (crudely, money), such that short-term interest rates match the official targets, which define the current monetary policy stance. In achieving this aim the central bank may: (a) Intervene into the interbank money market (the overnight market where banks lend to each other) to manage the daily supply of and demand for funds – so-called ‘open market operations’, which involve the buying and selling of government bonds; (b) buy certain financial assets at discounted rates from commercial banks; and (c) impose penal lending rates on banks who require urgent funds, In practice, most of the liquidity management is achieved through (a). That being said, central bank operations function to offset gluts and shortages of funds in the monetary system by altering the composition of bank reserves, cash, and bonds, and do not alter net financial assets of the non- government sectors.

Commercial banks maintain accounts with the central bank, which permit their reserves to be managed, and also the clearing system to operate smoothly. The central bank sets a number of different interest rates. It sets the so-called ‘lending rate’ (or discount rate), which is the rate it will lend reserves to the bank to on demand. The central bank also sets a ‘support rate’, which is paid on commercial bank reserves held by the central bank. Some nations set this rate to zero and in those cases persistent excess liquidity will drive the short-term interest rate to zero (as in Japan until mid 2006) unless the government sells bonds (or raises taxes). As we will show presently, the support rate becomes the interest-rate floor for the economy.

The central bank also sets the short-run or operational target interest rate, which represents the current monetary policy stance. It will typically be set by the central bank somewhere between the discount and support rate, which effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations. Other times all three rates might be the same, depending on what the central bank desires to achieve.

In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period. At the end of each day commercial banks have to appraise the status of their reserve accounts. Those that are in deficit can borrow the required funds from the central bank at the discount rate. Alternatively banks with excess reserves are faced with earning the support rate, which is typically below the current market rate of interest on overnight funds, if they do nothing. Clearly it is profitable for banks with excess funds to lend to banks with reserve deficits at market rates. Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate. When the system is in surplus overall this competition would drive the rate down to the support rate, which may be zero.

The central bank’s main liquidity management strategy is to conduct ‘open market operations’, the buying and selling of government debt. When the competitive pressures in the overnight funds market drives the interbank rate below the desired target rate, the central bank drains liquidity by selling government debt. This open market intervention therefore will result in a higher value for the overnight rate. Importantly, we characterise the debt-issuance as a monetary policy operation designed to provide interest-rate maintenance. This is in stark contrast to orthodox theory, which asserts that debt-issuance is an aspect of fiscal policy and is required to finance deficit spending. Clearly, when the central bank is offering a support rate for excess reserves equal to the current policy rate, then it can leave excess reserves in the banking system and maintain control of its policy stance.

The significant point for this discussion which we build on next to expose the myth of ‘crowding out’ is that net government spending (deficits) which are not taken into account by the central bank in its liquidity management, will manifest as excess reserves (cash supplies) in the clearing balances (bank reserves) of the commercial banks at the central bank. This situation is referred to as a ‘system-wide surplus’. In these circumstances, the commercial banks will be faced with earning the lower support rate return on surplus reserve funds if they do not seek profitable trades with other banks, who may be deficient of reserve funds. The ensuing competition to offload the excess reserves puts downward pressure on the overnight rate. However, these transactions necessarily net to zero, which means that interbank trading, cannot clear the system-wide surplus.

Accordingly, if the central bank desires to maintain the current target overnight rate, then it must drain this surplus liquidity by selling government debt or offer a competitive support rate.

The myth of financial crowding out

We now know that it is a myth to perpetuate the idea that a currency-issuing government is financially constrained. This myth underpins arguments by orthodox economists against government activism in macroeconomic policy. There is another persistent myth that needs to be dispelled – that government expenditures crowd out private expenditures through their effects on the interest rate.

We have seen that the central bank necessarily administers the risk-free interest rate and is not subject to direct market forces. The orthodox macroeconomic approach argues that persistent deficits ‘reduce national savings … [and require] … higher real interest rates and lower levels of investment spending’ (DeLong, 2002: 405). Unfortunately, proponents of this logic fail to understand that the central bank can choose to set and leave the interest rate at 0 per cent, regardless, should that be favourable to the longer maturity investment rates.

While we have learned that the funds that government spends ‘do not come from anywhere’ and taxes collected ‘do not go anywhere’, there are substantial liquidity impacts from net government positions. If the funds that purchase the government bonds come from government spending in the first place, as the accounting dictates, then any notion that government spending rations finite savings that could be used for private investment is a nonsense.

At the heart of this misconception is a flawed viewed of financial markets. The Classical economists advanced the so-called ‘loanable funds doctrine’ which claimed that the loanable funds market mediates saving and investment via interest rate variations. Thus, saving (supply of funds) responds positively to rising interest rates because savers can get a higher return and increase their future consumption possibilities. Investment (demand for funds) declines with the interest rate because the cost of funds to invest in (houses, factories, equipment etc) rises. In this theory, shortages of funds for lending push up interest rates and vice versa.

According to this theory, if the fiscal deficit rises and the government increases its borrowing then interest rates have to rise because there are now more borrowers in the market competing for the scarce savings. The higher interest rates then choke off some private investment spending. This spending is ‘crowded out’ by the government spending. In the 1930s, John Maynard Keynes demolished the ‘crowding out’ hypothesis, by demonstrating that total national saving rises when national income rises. In other words, when the government increases its net spending (that is, the deficit rises) it not only increases national income but total saving also rises. We have learned earlier in the chapter that deficit spending also creates new financial assets in the non-government sector, which show up as increased reserves in the banking system, once all the transactions (purchases and sales) are accounted for. These extra assets, held initially as bank account balances, are available to buy the newly issued government bonds. In this way, the sale of debt by the government is really ‘borrowing’ funds that the government has already spent into existence when it ran the deficit. The sale of bonds just alters the composition of the portfolio of assets that are held by the non-government sector (more interest-bearing bonds and less bank deposits). In that context, it makes no sense to say that government borrowing rations finite ‘savings’ which could alternatively finance private investment.

Ask yourself the question – what would happen if the government didn’t borrow from the private sector but instead allowed the central bank to buy its debt instead? Like all government spending, the treasury would spend by instructing the central bank to put money into the bank accounts of the recipients of the spending, which would involve ‘crediting’ the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. As a result, the commercial bank’s assets rise (reserves increase) and its liabilities also increase because a deposit would be made on behalf of the recipient of the government spending. Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth. Taxation does the opposite and so a fiscal deficit (spending greater than taxation) means that bank reserves increase and private net worth increases.

This means that there are likely to be excess reserves in the banking system, which then raises issues for the central bank about its liquidity management. The aim of the central bank is to ‘hit’ its ‘target’ or policy interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target. For a commercial bank, excess reserves constitute dead-money unless the central bank pays a return on them. If there is no return on the excess reserves held overnight, the banks will scurry to seek interest-earning opportunities by loaning to other banks in the interbank market, which might have a shortage of reserves. The excess reserves put downward pressure on the overnight interest rate because banks will accept anything above a zero return, which is what they get if they cannot rid themselves of the surplus funds. Faced with this competitive situation, the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target interest rate it seeks to maintain as its expression of the monetary policy stance. Should a support rate be paid on excess reserves, the interest rate would converge on that support rate. Any economic ramifications (like inflation or currency depreciation) would be due to lower interest rates (stimulating excessive nominal growth rates relative to the real capacity of the economy) rather than any notion of ‘printing money’.

What would happen if the government borrowed from the private sector to match its fiscal deficit? All that happens is that the banks reserves are reduced by the bond sales and privately-held deposits are swapped for bonds. In other words, the net worth of the non-government sector is not altered. What is changed is the composition of the asset portfolio held in the non-government sector. The only difference between the treasury borrowing from the central bank (as in OMF) and issuing debt to the private sector is that the central bank has to use different liquidity operations to maintain its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution). There are no differences in the impact that the fiscal deficits have on net worth in the non-government sector.

Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend. That is clearly not the case in a modern monetary economy. Building bank reserves does not increase the ability of the banks to lend just as draining them does not reduce the capacity of banks to lend. The banks will lend to credit worthy customers, knowing they can access bank reserves after the fact from a number of sources, with a guarantee that they can source them from the central bank if all other options fail. The banks are able to create credit whenever they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending. Bank loans simultaneously create new deposits that borrowers can then use to invest in capital formation (building productive capacity). We consider these banking operations more fully in Chapter 23. Even if the government borrowing drained the bank reserves that the initial government spending created, the central bank will always provide the desired reserves to the commercial banks to ensure the integrity of the payments system. There can be no shortage of reserves over any relevant period. There can be no squeeze on private investment arising from government borrowing.

Ultimately, private agents may refuse to hold any more cash or bonds. What would happen then? The private sector at the micro level can only dispense with unwanted cash balances in the absence of government bond sales by increasing their spending levels. Given the current tax structure, this reduced desire to net save would generate a private expansion and reduce the fiscal deficit, eventually restoring the portfolio balance at higher private employment levels with lower required fiscal deficits.

At this point it seems useful to us to summarise the main conclusions from the above discussion. First, the central bank sets the short-term interest rate based on its policy aspirations. Operationally, fiscal deficits put downward pressure on interest rates contrary to the myths that appear in macroeconomic textbooks about crowding out. The central bank can counter this pressure by selling government bonds, which is equivalent to government borrowing from the public. Second, the penalty for not borrowing is that the interest rate will fall to the bottom of the corridor prevailing in the country which may be zero if the central bank does not offer a return on reserves, For example, Japan has been able to maintain a zero interest rate policy for years with record fiscal deficits simply by spending more than it borrows. This also illustrates that government spending is independent of borrowing, with the latter best thought of as coming after spending. Third, government debt-issuance is a monetary policy consideration rather than being intrinsic to fiscal policy. Finally, a fiscal surplus describes from an accounting perspective what the government had done not what it has received.

The basic principles of Functional Finance

The fundamentals of MMT outlined in the previous sections 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 (emphasis in original).

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 conservaitve 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 that 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 artefacts left over from the old gold standard monetary systems. Lerner said the “government should borrow money only if it is desirable that 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 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 taxpayer. 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 the conservative economists considered this option taboo. 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.

Bank of England (2014) ‘Money creation in the modern economy’, Quarterly Bulletin, Quarter 1.

Bernanke, B. (2002) ‘Deflation: Making Sure “It” Doesn’t Happen Here’, Speech to the National Economists Club, Washington, D.C., November 21, 2002.

Bernanke, B. (2003) ‘Some Thoughts on Monetary Policy in Japan’, Remarks before the Japan Society of Monetary Economics, Tokyo, Japan, May 31, 2003.

Bossone, B. (2013a) ‘Time for the Eurozone to shift gear: Issuing euros to finance new spending’, VoxEu, April 8, 2013,

Bossone, B. (2013b) ‘Italy, Europe: Please do something!’, EconoMonitor, April 19, 2013. (

Bossone, B. and Wood, R. (2013) ‘Overt Money Financing of Fiscal Deficits: Navigating Article 123 of the Lisbon Treaty’, July 22, 2013.

Committee on Economic and Monetary Affairs (2013a) ‘Draft Report on the European Central Bank Annual Report for 2012’, European Parliament, ECON/7/12316, June 11, 2013.

Committee on Economic and Monetary Affairs (2013b) ‘Amendments 1-247 – Draft report – on the European Central Bank Annual report for 2012’, European Parliament, ECON/7/12316, July 12, 2013.

Committee on Economic and Monetary Affairs (2013c) ‘Report on the European Central Bank Annual report for 2012’, European Parliament, ECON/7/12316, November 13, 2013.

ECB (2012a) ‘Monthly Bulletin, 05/2012.

ECB (2012b) ‘Opinion of the European Central Bank of 24 January 2012 on a guarantee scheme for the liabilities of Italian banks and on the exchange of lira banknotes (CON/2012/4).

ECB (2013) ‘Annual Report 2012’, European Central Bank.

ECB (2014a) ‘Introductory statement to the press conference (with Q&A)’, Mario Draghi, President of the ECB, Frankfurt am Main, 3 April 2014.

ECB (2014b) ‘ELA Procedures’, Accessed April 18, 2014.

Eurostat (2014a) ‘Euro area annual inflation down to 0.5%’, Flash Estimate March 2014, published March 31, 2014.

Eurostat (2014b) ‘Euro area unemployment rate at 11.9%’, February 2014, published April 1, 2014.

Eurostat (2014c) ‘Seasonally adjusted government deficit down to 3.1% of GDP in the euro area’, February 3, 2014.

Federal Reserve Bank of New York (2008) ‘Divorcing Money from Monetary Policy’, Economic Policy Review, September, 41-56.

Frankfurter Allgemeine (2012) ‘Die Angst vor der Inflation’, September 23, 2012.

Friedman, M. (1959a) ‘Statement and Testimony’, Joint Economic Committee, 86th US Congress, 1st Session, May 25.

Friedman, M. (1959b) A Program for Monetary Stability. New York, Fordham University Press.

Friedman, M. (1968) ‘The Role of Monetary Policy’, American Economic Review, 58(1), 1-17.

Friedman, M. (1969) The optimum quantity of money, and other essays, Chicago, Aldine Publishing Company.

Gordon, D.M. (1972) Theories of poverty and underemployment, Lexington, Mass: Heath, Lexington Books.

Lagarde, C. (2014) ‘The Road to Sustainable Global Growth-the Policy Agenda’, Speech to the School of Advanced International Studies, Johns Hopkins University, Washington, DC, April 2, 2014.

Lavoie, M. (1984) ‘The endogeneous flow of credit and the Post Keynesian theory of money’, Journal of Economic Issues, 18, 771-797.

McCulley, P. and Pozsar, Z. (2013) ‘Helicopter money: or how I stopped worrying and love fiscal-monetary cooperation’, Global Society of Fellows, 7 January 7, 2013.

MNI (2014) ‘Interview with Jens Weidmann’, March 21, 2014.

Ricardo, D. (1951) ‘Essay on the Funding System’, in P. Sraffa (ed) The Works and Correspondence of David Ricardo, Volume IV, Cambridge, Cambridge University Press.

Turner, A. (2013) ‘Debt, Money and Mephistopheles: How do we get out of this mess?’, Speech to Cass Business School, London, February 6, 2013.

von Goethe, J.W. (1888) ‘Faust: A Tragedy’, London, Ward Lock and Co.

Weidmann, J. (2012) ‘Money Creation and Responsibility’, Speech at the 18th colloquium of the Institute for Bank-Historical Research (IBF), Frankfurt, September 28, 2012.

White, W. (2013) ‘Overt Monetary Financing (OMF) and Crisis Management’, Project-Syndicate, June 12, 2013.–omf–and-crisis-management

Wood, R. (2012) ‘The economic crisis: How to stimulate economies without increasing public debt’, Policy Insight, No. 62, Centre for Economic Policy Research, August.

Wood, R. (2013a) ‘Conventional and Unconventional Fiscal and Monetary Policy Options’, EconoMonitor, June 20, 2013.

Wood, R. (2013b) ‘Overt Money Financing and Public Debt’, September 3, 2013.

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

This Post Has 2 Comments

  1. “Government spending is not inherently revenue constrained”

    In light of the “don’t think of a pink elephant” concept, is it worth rewording this subheading as ‘Government spending limited solely by real resource availability’, or something along those lines?

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