Fiscal sustainability 101 – Part 2

This is Part 2 of my little mini-series on what we might conceive fiscal sustainability to be. In Part 1 we considered a current debate on the National Journal, which is a US discussion site where experts are invited to debate a topic over a period of days. By breaking the different perspectives that have been presented to the discussion, we can easily see where the public gets its misconceived ideas from about the workings of public deficits and the dynamics of the monetary system – its leaders. My aim in this 3-part series is to further advance an understanding of how a fiat monetary system operates so that readers of this blog (growing in numbers) can then become leaders in their own right and provide some re-education on these crucial concepts. So read on for Part 2.

Recall from yesterday, Fed Reserve Chairman Ben Bernanke defined fiscal sustainability:

… as achieving a stable ratio of government debt and interest payments to gross domestic product, and setting tax rates at levels that don’t impede economic growth.

Throughout Part 1 of this series I provided some hints as to what might or might not be included in a sensible definition of fiscal sustainabilty – one that is based on a thorough understanding of the way the fiat monetary system operates. Here is the list of hints developed so far in Part 1:

  • Saying a government can always credit bank accounts and add to bank reserves whenever it sees fit doesn’t mean it should be spending without regard to what the spending is aimed at achieving. To see the difference provides a vital clue as to what “fiscal sustainability” means.
  • Advancing public purpose is another component of what “fiscal sustainability” means. You cannot define it in its own accounting terms – some given deficit size relative to GDP or whatever.
  • We won’t find a definition of “fiscal sustainability” conceptualised by some level of the public debt/GDP ratio.
  • Fiscal sustainability is directly related to the extent to which labour resources are utilised in the economy. The goal is to generate full employment.
  • The concept of fiscal sustainability is not defined in terms of any notion of public solvency. A sovereign government is always solvent (unless it chooses for political reasons not to be!).
  • The concept of fiscal sustainability will not include any notion of foreign “financing” limits or foreign worries about a sovereign government’s solvency.

So it is back to the contributions to the National Journal debate to see whether we can develop any more principles that will help us define fiscal sustainability.

The next commentator come expert (not!) is Grover Norquist who is listed as the President, Americans For Tax Reform, which is a body set up at the request of Ronald Reagon and which wants small government and low taxation. He says:

Fiscal sustainability means moving from defined benefit/pay as you go/Ponzi sheme financing of Social Security and Medicare to fully funded defined contribution pensions and health care funding. This is not just a government funding problem. Private companies that have defined benefit pensions have found themselves uncompetitive compared to defined contribution pensions.

Note the household (private sector entity)-government analogy again. Flawed at its very essence but continually wheeled out by the gold standard logicians. They ought to take a break from their desk and read some history. They could focus on the 1970s and they might find out that Bretton Woods collapsed, that convertibility went with it, that fixed exchange rate regimes are mostly gone (certainly as a world standard) and all of that. Then they might understand that they just sound plain ignorant when they make these statements.

They might be better saying … well governments for political reasons – to appease the rampant neo-liberalism that they helped to create – place voluntary constraints on themselves and act as if they were still in the Bretton Wood’s era – that is, they might voluntarily impose artificial financing rules on themselves. But in reality this is a denial of the essence of the fiat monetary system that we now live in and there is thus no economic basis for these constraints. But politically we support them because they divert power to the rich and the capital classes by keeping unemployment high and they have successfully redistributed national income from the workers to profits.

If they said that I would have more respect for the honesty. Not an ounce of respect for their values. But at least this is what is actually going on. The problem is that they don’t they that. They lie and distort the public debate – through their superior access to the media etc – and make out that these voluntary restraints are in fact economic and intrinsic. You might say I have contempt for this dissembling logic!

Hint: the concept of fiscal sustainability will not include any notion of financing imperatives that a sovereign government faces nor invoke the fallacious analogy between a household and the government.

Enter Robert Reischauer, President, The Urban Institute, which is probably on the progressive side of the debate and aims to advance public policy to improve urban centres. Reischauer says:

… over the longer run, we should ask whether we want we want to live always clinging to the edge of fiscal un-sustainability or would it be better to have a public sector that is a bit further from the cliff’s edge, one more capable of responding to the inevitable economic and political crises that will occur. We have to ask at what level we want to stabilize the debt to GDP ratio: should it be at 80 percent, 40 percent, or, perhaps the 25 percent achieved in the mid 1970s?

Conclusion: we can dismiss this view immediately. Setting some debt to GDP ratio is a futile meaningless task. If you don’t want the private sector to have more financial asset choice then the sovereign government can always stop selling bonds. Simple as that. The net spending will continue as planned but the new net financial assets that are added by the deficits will still be held by the private sector – as bank reserves or in other ways they choose. The government will just deny them the ability to convert low or zero yielding bank reserves into interest-bearing government bonds.

Anytime the private sector gets sick of having this choice would be fine for any sovereign government. They can easily address the monetary implications of this (no debt issue) by just allowing the short-term interest rate to fall to zero or whatever support level the central bank pays on excess reserves. The government could easily create an equivalence between bank reserves and government debt by paying the short-term target interest rate (the central bank target) on excess overnight reserves. Then the central bank would maintain control over its monetary policy target and no public debt would have to be issued to drain the excess reserves and curtain interbank competition for overnight funds. Simple as that!

Reischauer echos the sentiments of a “deficit dove”. This search will locate my blogs where I have discussed what a deficit dove thinks. Recall these are characters who don’t intrinsically hate deficits (like some of the conservatives) but are so beguiled by the lie that we still live in a gold standard that they take a cautious approach to deficits and talk in terms of stable debt to GDP ratios – just as Bernanke note above. Many so-called progressive economists fall into this camp (unfortunately).

So we get this logic:

The higher the ratio at which stability is achieved, the larger the deficits the government can incur while keeping the ratio stable. The higher the ratio, the larger the fraction of spending devoted to interest payments and the more exposed the budget is to adverse interest rate movements and pressure from our foreign creditors. Furthermore, taxpayers already upset that they don’t get their money’s worth in services, won’t be happy campers when a growing fraction of their taxes are absorbed paying for past services — which is what interest payments represent. For these reasons, long run sustainability should involve lowering the debt to GDP ratio from the projected 80 plus percent range back to levels that are more compatible with healthy economic growth and political stability.

All the errors of logic that you can make are demonstrated here. First, the deficit-doves still invoke the notion of an a priori government budget constraint (GBC) which imposes financial limitations on the government’s ability to fulfill its socio-economic policy ambitions. Instead of attacking the use of deficits per se, as the more extreme conservatives do, the deficit-doves talk in terms of providing more room for the deficit to work but always within the constraint imposed by the debt/GDP ratio.

This commentator makes the obvious point that the more debt there is outstanding the higher will be the interest payments forthcoming. That is, the greater is the income add to the debt holders which allows them to pursue wider spending choices and underpin employment as a consequence. There is no recognition of the monetary policy imperatives (maintaining interest rate targets) involved in issuing the debt in the first place. The erroneous assertion made, without critical reflection, is that the debt somehow “funded” the spending because the spending is “revenue constrained” because the government is the same as a household. Well it is not and it is not and it is not!

Second, the commentator makes the claim that the budget balance will be subject to “adverse interest rate movements” and “pressure from our foreign creditors”. How does that work? The government (and you will know by now that I consolidate the central bank and the treasury operations into this term) sets the short-term interest rate. Further, the coupon (interest) rate on the public debt is determined when it is issued (whether by tap or auction) and the government can manipulate the auction price if it wanted to by altering the volume of debt being issued. It doesn’t do this but it always can. If at anytime the government wanted to reduce its interest bill (and therefore reduce its income add to the non-government sector) but at the same wanted to keep issuing public debt then it can always cut interest rates which would drive down the yields on any new issues. Simple as that!

But moreoever, there is never a question that paying a $ on public debt interest means a $ cannot be spent on a hospital! The government can always do both if it feels that will help fulfill its public purpose.

Further, the idea that “foreign creditors” (by which I assume he means foreign holders of public debt) can in some way impose difficulties on the government of issue is nonsensical in the extreme. What happens if they stop buying the debt? Answer: they stop buying the debt. Further answer: they do something else with their currency. Futher answer: their currency probably rises in value and they kill their export sector. This might actually improve conditions for their own citizens who get more access to domestic resources (not exported) and might force the government to spend more in the domestic economy to fill the spending gap left by the decline in exports. So all good for the foreign citizens.

But for the government of issue – they don’t need the foreign governments to buy the debt. The government of issue can still spend as it desires. Remember that the Chinese only get hold of $USD if the US Government spends them first! So there is really no issue.

Third, the taxpayer funds bogey person appears – again! Taxpayers do not fund anything. Governments fund spending by spending – again! Whether the Government increases or decreases taxes depends on whether it wants to have less or more spending capacity in the private sector. These decisions have nothing fundamentally to do with the spending decision unless the economy is already at full capacity and the government wants more public goods and less private goods in the overall GDP goods and services mix. Then it might increase net spending and also increase taxes (for example). But never conflate this simultaneity with the notion that the taxe rises are “financing” the spending increases.

Further, as noted above, even within a mainstream framework, public debt is used to “pay for” large infrastructure projects which provide a stream of services to future generations. That is exactly why orthodox economists (including the deficit-doves) say you should use debt to “fund” the projects rather than taxes to better align the “burden of payment with the generations that will enjoy the benefits over many periods. So this idea that “interest payments represent past services” is nonsensical even within the orthodox model.

As an aside, presumably this is the rationale that The Greens use when they say that debt should be used to “fund” capital development projects. It is neo-liberal in conception but exploits this intertemporal distribution of burden idea that is embedded in orthodox theory.

The intertemporal distribution of burden logic also means that notions that scare campaigns such as “our kids will be paying for our sins” argument that is being used at present by the deficit-debt nazis is also nonsensical from a mainstream framework unless the debt was being used to buy everyone an ice-cream today – that is, no endurable benefits.

So even within the orthodox paradigm these notions are ridiculous.

But of-course the fundamental conception is misconceived – that is, at the level of first principles. The public debt issue did not fund any spending even though government spending should, in part, be used to develop public infrastructure which delivers long-term benefits to current and future generations. Just take a drive down the Great Ocean Road – built in the 1930s as a public works job creation project! Taxes do not fund any spending so rising interest servicing obligations on government have no necessaryt implications for taxation in the future. Taxes might rise in the future – they might fall – they might stay unchanged. But whatever the outcome there is no intrinsic relationship with the evolution of the deficit.

Conclusion: Reischauer doesn’t get it at all.

Hint: – we will not be tying the concept of fiscal sustainability to any accounting entity such as a debt/GDP ratio.

Another contributor to the National Journal debate was James K. Galbraith, Professor of Economics, University of Texas, who works with us within the modern monetary theory camp. So you will expect he will say something quite different to the commentators I have covered from the debate to date (in Fiscal sustainability 101 – Part 1 and above).

Galbraith begins by saying that:

Chairman Bernanke may, if he likes, try to define “fiscal sustainability” as a stable ratio of public debt to GDP. But this is, of course, nonsense. It is Ben Bernanke as Humpty-Dumpty, straight from Lewis Carroll, announcing that words mean whatever he chooses them to mean …. A stable ratio of federal debt to GDP may or may not be the right policy objective. But it is neither more nor less “sustainable,” under different economic conditions, than a rising or a falling ratio.

Galbraith correctly points out that at various times during the course of US history, the debt/gdp ratio been risen and fallen with the fortunes of the economy – not driving the fortunes but reflecting them. So during World War II it soared and then fell back as peace arrived and growth ensued.

His point is the valid one – the ratio wanders around “all over the shop” and the real question if whether it is “appropriate to the underlying economic conditions”. So you can see that it is the underlying economic conditions that should be the focus of fiscal policy settings not the accounting data (for example, debt/GDP ratios) that “record” what the government has been doing to fulfill its public purpose charter.

Galbraith then tells us that:

History has a second lesson. In a crisis, the ratio of public debt to GDP must rise. Why? Because a crisis … is a national emergency, and national emergencies demand government action. That was true of the Great Depression, true of war, and true of the Great Crisis we’re now in. Moreover, we’ve designed the system to do much of this work automatically. As income falls and unemployment rises, we have an automatic system of progressive taxation and relief, which generates large budget deficits and rising deficits. Hooray! This is precisely what puts dollars in the pockets of households and private businesses, and stabilizes the economy. Then, when the private economy recovers, the same mechanisms go to work in the opposite direction.

After concluding that the rising “ratio of debt to GDP” currently, just represents a “strong fiscal response to the crisis” which was required and is to be applauded, Galbraith says that:

It is therefore a big mistake to argue that the next thing the administration and Congress should do, is focus on stabilizing the debt-to-GDP ratio or bringing it back to some “desired” value. Instead, the ratio should go to whatever value is consistent with a policy of economic recovery and a return to high employment. The primary test of the policy is not what happens to the debt ratio, but what happens to the economy.

Galbraith also reflects on the previous commentator’s claims that “a very high public-debt-to-GDP ratio leaves the US vulnerable to pressure from foreign creditors” (aka the Chinese)! I covered this point above. Galbraith offers this perspective. This argument:

… displays a very vague view of monetary operations and the determination of interest rates. The reality is in front of our noses: Ben Bernanke sets whatever short term interest rate he likes. And Treasury can and does issue whatever short-term securities it likes at a rate pretty close to Bernanke’s fed funds rate. If the Treasury doesn’t like the long term rate, it doesn’t need to issue long-term securities: it can always fund itself at very close to whatever short rate Ben Bernanke chooses to set … The Chinese can do nothing about this. If they choose not to renew their T-bills as they mature, what does the Federal Reserve do? It debits the securities account, and credits the reserve account! This is like moving funds from a savings account to a checking account. Pretty soon, a Beijing bureaucrat will have to answer why he isn’t earning the tiny bit of extra interest available on the T-bills. End of story.

I could have written that myself although I wouldn’t use the terminology “they could always fund themselves” because it invokes the notion that the government is revenue-constrained. Jamie knows that isn’t true so I would just steer clear from using those invocations – because in the hands of the ignorant they became dangerous attacks on the operations of fiscal policy!


In Part 3, I will provide a brief summary of what all this means for a meaningful and productive conceptualisation of fiscal sustainability. That will come tomorrow if all goes well.

You will note that I have not said anything about politicial sustainability. I am not a political scientist. But political sustainability is whatever can be deemed acceptable by the people who vote for the polity. But what people think about the economic conduct of the government should not be distorted by mistruths about the essence of the fiat monetary system.

The way the modern monetary system works is neither left wing or right wing. The fundamental operations of the system are what they are. You can then impose whatever ideology you like on those operations although I accept a deeper ideological critique can be made of using fiat money in the first place!

Digression: Former Treasurer announces he’s going


This Post Has 5 Comments

  1. Bill, I understand your logic completely. The government can spend without any constraint – this increases bank reserves. It, with the central bank can (by choice) issue bonds to target the overnight rates etc or pay interest on (excess) reserves. It doesn’t need to balance its book like a corporate. The money can be used to employ people in various development projects and it won’t really increase inflation. Also in some of your posts we learned that the central bank and the government do not really have much control over the amount of broad money – a bank will loan anyone whom it thinks is credit worthy and look for reserves later. The government is never in debt – only people go into debt.

    However, shouldnt there be a mechanism for controlling the broad money ?

  2. Dear Ramaman

    Your understanding of the way the monetary system works is excellent.

    In terms of controlling broad money, what mechanism would work? It has been tried without success. Moreover, it is not something that you need to worry about while the economy is below full capacity. After that, fiscal policy can more or less keep activity levels at full capacity which will keep a lid on nominal demand. If nominal demand overheats (relative to capacity) then fiscal policy has to be tightened. That will choke off excess demand soon enough. It is not an exact science though.

    best wishes

  3. The way I see it, there are a few related hypotheses Bill and/or others have raised related to this issue:

    a) it is essentially impossible to control broad money.
    b) broad money supply does not determine inflation, or anything else very much.
    c) what can be controlled is the short term interest rate.
    d) interest rates do have an impact on inflation (this too is contentious in some circles).

    So a) doesn’t matter very much since we have c). Of course some would argue that d) is false so c) is not necessary either.

  4. Dear Sean

    Yes, by (d) I presume you mean that the manipulation of interest rates may be used to control inflation and that inflation expectations may have an influence on the spreads at the longer end of the yield curve. Both are true in reality. But the way in which interest rate manipulation (that is, monetary policy) impacts on inflation is not clear – there are complex distributional issues that are at play – so rising rates increase costs for borrowers and may choke of aggregate demand but equally they increase incomes for those with interest-rate sensitive portfolios which may add to aggregate demand. So within normal ranges of change there may be very little impact in net terms. That is why I favour the use of fiscal policy – it is more predictable in its impacts.

    best wishes

  5. Bill,
    I certainly agree that interest rates (particularly longer-dated) are strongly influenced by inflation expectations. As for the other direction, it is obviously standard thinking that central bank influence of the short-rate can influence (i.e. manage) inflation. An example of the contention on this point I had in mind (beyond, perhaps, your own) is in the writing of Fisher Black:

    I can find no mechanism consistent with general equilibrium by which open market operations can affect the real economy, nominal interest rates, or the price level. Changing the private sector’s holdings of currency, reserves, and government bonds simply makes people want to reverse the open market operation. It does not make them want to change their rates of consumption or investment.

    When I relax the assumptions of the general equilibrium model a bit, I find that open market operations can have an impact, but not on the level of output or the inflation rate. Rather, the government can affect interest rates, raising some and lowering others, thus changing the
    shape of the yield curve.

    from Fisher Black, Exploring General Equilibrium (1995)

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