I have been travelling for most of today so I have to keep this post…
In this blog I will complete my analysis of the concept of fiscal sustainability by bringing together the discussion developed in Part 1 and Part 2 into some general principles. The aim is to provide a blueprint to cut through the deceptions and smokescreens that are used to deny fiscal activism and leave economies wallowing in persistently high levels of unemployment. So read on.
In considering the offerings from various commentators that participated in the National Journal debate I came up with several hints. Here they are again.
- 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. I will come back to that but it is a 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 financing imperatives that a sovereign government faces nor invoke the fallacious analogy between a household and the government.
- The concept of fiscal sustainability cannot be sensibly tied to any accounting entity such as a debt/GDP ratio.
- The concept of fiscal sustainability will not include any notion of foreign “financing” limits or foreign worries about a sovereign government’s solvency.
These hints can be re-ordered under some general headings which in turn suggest some overriding principles that should be used when appraising whether a particular fiscal policy strategy is sustainable or not.
Advancement of public purpose
The only sensible reason for accepting the authority of a national government and ceding currency control to such an entity is that it can work for all of us to advance public purpose. In this context, one of the most important elements of public purpose that the state has to maximise is employment. Once the private sector has made its spending (and saving decisions) based on its expectations of the future, the government has to render those private decisions consistent with the objective of full employment.
Given the non-government sector will typically desire to net save (accumulate financial assets in the currency of issue) over the course of a business cycle this means that there will be, on average, a spending gap over the course of the same cycle that can only be filled by the national government. There is no escaping that.
So then the national government has a choice – maintain full employment by ensuring there is no spending gap which means that the necessary deficit is defined by this political goal. It will be whatever is required to close the spending gap. However, it is also possible that the political goals may be to maintain some slack in the economy (persistent unemployment and underemployment) which means that the government deficit will be somewhat smaller and perhaps even, for a time, a budget surplus will be possible.
But the second option would introduce fiscal drag (deflationary forces) into the economy which will ultimately cause firms to reduce production and income and drive the budget outcome towards increasing deficits.
Ultimately, the spending gap is closed by the automatic stabilisers because falling national income ensures that that the leakages (saving, taxation and imports) equal the injections (investment, government spending and exports) so that the sectoral balances hold (being accounting constructs). But at that point, the economy will support lower employment levels and rising unemployment. The budget will also be in deficit – but in this situation, the deficits will be what I call “bad” deficits. Deficits driven by a declining economy and rising unemployment.
In this context, the introduction of a Job Guarantee, which is an unconditional job offer by the national government at a fixed (minimum) wage, is a way to achieve high employment levels with the lowest spending impulse. So if the government is worried about nominal demand expansion relative to the real capacity of the economy it, an employment guarantee will be a much better way of sustaining full employment than trying to expand employment by stimulating the private market either by stimulating private firms (buying their output) or by competing with private firms for labour at market prices.
Clearly, a mix of employment guarantee and general spending is preferable to ensure an adequate volume of employment is maintained by high quality public goods provision is achieved.
So fiscal sustainability requires that the government fills the spending gap with “good” deficits at levels of economic activity consistent with full employment – 2 per cent unemployment and zero underemployment.
It cannot be defined independently of full employment. Once the link between full employment and the conduct of fiscal policy is abandoned, we are effectively admitting that we do not want government to take responsibility of full employment (and the equity advantages that accompany that end).
Understanding the monetary environment
Any notion of fiscal sustainability has to be related to intrinsic nature of the monetary system that the government is operating within. It makes no sense to comment on the behaviour of a government in a fiat monetary system using the logic that applies to a government in a gold standard where the currency was convertible to another commodity of intrinsic value and exchange rates were fixed.
The constraints that the latter monetary system imposed on the national government – necessity of financing spending – tying monetary policy to defending the exchange parity – do not apply to a national government in a fiat monetary system. This is not my opinion or interpretation. It is just a reflection of the fundamental differences between the two monetary systems.
The gold standard is gone. Most countries operate in fiat monetary systems. We should never forget that and reject commentary logic that distorts or denies that intrinsic fact.
We should then understand that a government operating in a fiat monetary system, may adopt, for whatever warped reasons, voluntary restraints that allow it to replicate the operations of a government during a gold standard.
These constraints may include issuing public debt $-for-$ everytime they spend beyond taxation. They may include setting particular ceilings relating to deficit size; limiting the real growth in government spending over some finite time period; constructing policy to target a fixed or unchanging share of taxation in GDP; placing a ceiling on how much public debt can be outstanding; targetting some particular public debt to GDP ratio.
All these restraints are gold standard type concepts and applied to governments who were revenue-constrained. They have no intrinsic applicability to a sovereign government operating in a fiat monetary system. So while it doesn’t make any sense to me for a government to put itself in a strait-jacket which typically amounts to it failing to achieve high employment levels, the fact remains that a government can do it.
But do not be deceived – these are voluntary restraints. They are voluntary applications of constraints applicable to the monetary system that we abandoned long ago to the current monetary system where they have no applicability.
In general, the imposition of these restraints reflect ideological imperatives which typically reflect a disdain for public endeavour and a desire to maintain high unemployment to reduce the capacity of workers to enjoy their fair share of national production (income).
Accordingly, the concept of fiscal sustainability does not include any recognition of the legitimacy of these voluntary restraints. These constraints have no application to a fiscally sustainable outcome. They essentially deny the responsibilities of a national government to ensure public purpose, as discussed above, is achieved.
Understanding what a sovereign government is
A national government in a fiat monetary system has specific capacities relating to the conduct of the sovereign currency. It is the only body that can issue this currency. It is a monopoly issuer, which means that the government can never be revenue-constrained in a technical sense (voluntary constraints ignored). This means exactly this – it can spend whenever it wants to and has no imperative to seeks funds to facilitate the spending.
This is in sharp contradistinction with a household (generalising to any non-government entity) which uses the currency of issue. Households have to fund every dollar they spend either by earning income, running down saving, and/or borrowing. Clearly, a household cannot spend more than its revenue indefinitely because it would imply total asset liquidation then continuously increasing debt. A household cannot sustain permanently increasing debt. So the budget choices facing a household are limited and prevent permament deficits.
These household dynamics and constraints can never apply intrinsically to a sovereign government in a fiat monetary system.
A sovereign government does not need to save to spend – in fact, the concept of the currency issuer saving in the currency that it issues is nonsensical. A sovereign government does not need to borrow to spend. A sovereign government can sustain deficits indefinitely without destabilising itself or the economy and without establishing conditions which will ultimately undermine the aspiration to achieve public purpose.
Further, the sovereign government is the sole source of net financial assets (created by deficit spending) for the non-government sector. All transactions between agents in the non-government sector net to zero. For every asset created in the non-government sector there is a corresponding liability created $-for-$. No net wealth can be created. It is only through transactions between the government and the non-government sector create (destroy) net financial assets in the non-government sector.
This is an accounting reality that means that if the non-government sector wants to net save in the currency of issue then the government has to be in deficit $-for-$. The accumulated wealth in the currency of issue is also the accounting record of the accumulated deficits $-for-$.
So when the government runs a surplus, the non-government sector has to be in deficit. There are distributional possibilities between the foreign and domestic components of the non-government sector but overall that sector’s outcome is the mirror image of the government balance.
To say that the government sector should be in surplus is to also aspire for the non-government sector to be in deficit. In a nation such as Australia, where the foreign sector is typically in deficit (foreigners supplying their savings to us), the accounting relations mean that a government surplus will always be reflected in a private domestic deficit. This cannot be a viable growth strategy because the private sector (which faces a financing contraint) cannot be in deficits on an on-going basis. Ultimately, the fiscal drag will force the economy into recession (as private sector agents restructure their balance sheets by saving again) and the budget will move via automatic stabilisers into defict.
The relationships between a sovereign government and the non-government sector cannot be defied. Private debt build up can allow the government to run surpluses for some time (when the balance of payments is in deficit) but not for very long.
Sub-national governments who use the currency of issue are akin to a household in that they face financing constraints. The only (and major) differences between a household and a sub-national government is that the latter typically has the power to tax (or levy fines) and can thus access cheaper funds in the debt markets as a consequence. While a sub-national government does have some risk of insolvency the reality is that it is extremely low and close to zero.
Accordingly, the concept of fiscal sustainability involves a conceptualisation of a government which is free of financial constraints and has a range of possibilities that are not available to any non-government entity. It would never invoke a notion of public solvency. A sovereign government is always solvent (unless it chooses for political reasons not to be!)
Further, given the non-government sector will typically net save in the currency of issue, a sovereign government has to run deficits more or less on a continuous basis. The size of those deficts will relate back to the pursuit of public purpose.
Understanding why governments tax
In a fiat monetary system the currency has no intrinsic worth. Further the government has no intrinsic financial constraint. Once we realise that government spending is not revenue-constrained then we have to analyse the functions of taxation in a different light. The starting point of this new understanding is that 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.
In this way, it is clear that the imposition of taxes creates unemployment (people seeking paid work) in the non-government sector and allows a transfer of real goods and services from the non-government to the government sector, which in turn, facilitates the government’s economic and social program.
The crucial point is that the funds necessary to pay the tax liabilities are provided to the non-government sector by government spending. Accordingly, government spending 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 (government taxing and spending) into a non-monetary economics that raises the spectre of involuntary unemployment. As a matter of accounting, for aggregate output 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).
Unemployment occurs when the private sector, in aggregate, desires to earn the monetary unit of account, 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 spending.
The purpose of State Money is for the government to move real resources from private to public domain. It does so 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.
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 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 decisions in force at any particular time.
For a time, inadequate levels of net government spending can continue without rising unemployment. In these situations, as is evidenced in Australia over the last several years 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 attempt to restructure their balance sheets to make them less precarious and as a consequence the demand for debt slows and the economy falters. In this case, any fiscal drag (inadequate levels of net 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 (and going further into debt) at the previous rate, then the Government can increase spending and purchase goods and services and full employment is maintained. The alternative is unemployment and a recessed economy.
Accordingly, the concept of fiscal sustainability does not entertain notions that the continuous deficits required to finance non-government net saving desires in the currency of issue will ultimately require high taxes. Taxes in the future might be higher or lower or unchanged. These movements have nothing to do with “funding” government spending.
Understanding why governments issue debt
The fundamental principles that arise in a fiat monetary system are as follows.
- The central bank sets the short-term interest rate based on its policy aspirations.
- Government spending is independent of borrowing which the latter best thought of as coming after spending.
- Government spending provides the net financial assets (bank reserves) which ultimately represent the funds used by the non-government agents to purchase the debt.
- Budget deficits put downward pressure on interest rates contrary to the myths that appear in macroeconomic textbooks about ‘crowding out’.
- 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 easily maintains a zero interest rate policy with record budget deficits simply by spending more than it borrows.
- Government debt-issuance is a ‘monetary policy’ consideration rather than being intrinsic to ‘fiscal policy’, although in a modern monetary paradigm the distinctions between monetary and fiscal policy as traditionally defined are moot.
Accordingly, debt is issued as an interest-maintenance strategy by the central bank. It has no correspondence with any need to fund government spending. Debt might also be issued if the government wants the private sector to have less purchasing power.
Further, the idea that governments would simply get the central bank to “monetise” treasury debt (which is seen orthodox economists as the alternative “financing” method for government spending) is highly misleading. So debt monetisation is usually referred to as a process whereby the central bank buys government bonds directly from the treasury. In other words, the federal government borrows money from the central bank rather than the public. Debt monetisation is the process usually implied when a government is said to be printing money. Debt monetisation, all else equal, is said to increase the money supply and can lead to severe inflation.
However, fear of debt monetisation is unfounded, not only because the government doesn’t need money in order to spend but also because the central bank does not have the option to monetise any of the outstanding federal debt or newly issued federal debt.
As long as the central bank has a mandate to maintain a target short-term interest rate, the size of its purchases and sales of government debt are not discretionary. Once the central bank sets a short-term interest rate target, its portfolio of government securities changes only because of the transactions that are required to support the target interest rate. The central bank’s lack of control over the quantity of reserves underscores the impossibility of debt monetisation. The central bank is unable to monetise the federal debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to the support rate. If the central bank purchased securities directly from the treasury and the treasury then spent the money, its expenditures would be excess reserves in the banking system. The central bank would be forced to sell an equal amount of securities to support the target interest rate. The central bank would act only as an intermediary. The central bank would be buying securities from the treasury and selling them to the public. No monetisation would occur.
Further, the concept of debt monetisation is inapplicable. However, the central bank may agree to pay the short-term interest rate to banks who hold excess overnight reserves. This would eliminate the need by the commercial banks to access the interbank market to get rid of any excess reserves and would allow the central bank to maintain its target interest rate without issuing debt.
Accordingly, the concept of fiscal sustainability should never make any financing link between debt issuance and net government spending. There is no inevitability for debt to rise as deficits rise. Voluntary decisions by the government to make such a link have no basis in the fundamentals of the fiat monetary system.
Setting budget targets
Any financial target for budget deficits or the public debt to GDP ratio can never be a sensible for all the reasons outlined above. It is highly unlikely that a government could actually hit some previously determined target if it wasn’t consistent with the public purpose aims to create full capacity utilisation. As long as there is deficiencies in aggregate demand (a positive spending gap) output and income adjustments will be downwards and budget balances and GDP will be in flux.
The aim of fiscal policy should always be to fulfill public purpose and the resulting public debt/GDP ratio will just reflect the accounting flows that are required to achieve this basic aspiration.
Accordingly, the concept of fiscal sustainability cannot be sensibly tied to any accounting entity such as a debt/GDP ratio.
First, we have learned that exports are a cost and imports provide benefits. This is not the way that mainstream economists think but reflect the fact that if you give something away that you could use yourself (export) that is a cost and if you are get something that you do not previously have (import) that is a benefit. The reason why a country can run a trade deficit – more imports than exports – is because the foreigners (who sell us imports) want to accumulate financial assets in $AUD relative to our desire to accumulate their currencies as financial assets.
This necessitates that they send more real goods and services to us than they expect us to send to them. For as long as that lasts this real imbalance provides us with net benefits. If the foreigners change their desires to hold financial assets in $AUD then the trade flows will reflect that and our terms of trade (real) will change accordingly. It is possible that foreigners will desire to accumulate no financial assets in $AUD which would mean we would have to export as much as we import.
When foreigners demand less $AUD, its value declines. Prices rise to some extent in the domestic economy but our exports become more competitive. This process has historically had limits in which the fluctuations vary. At worst, it will mean small price rises for imported goods. If we think that depreciation will be one consequence of achieving full employment via net government spending then we are actually saying that we value having access to cheaper foreign travel or luxury cars more than we value having all people in work. It means that we want the unemployed to “pay” for our cheaper holidays and imported cars.
We might want to have those values embedded in public policy but I don’t think the concept of fiscal sustainability should reflect these perverse ethical standards.
Further, foreigners do not fund the spending of a sovereign government. If the Chinese do not want to buy US Government bonds then they will not. The US government will still go on spending and the Chinese will have less $USD assets. No loss to the US.
Accordingly, the concept of fiscal sustainability does not include any notion of foreign “financing” limits or foreign worries about a sovereign government’s solvency.
Understanding what a cost is
The deficit-debt debate continually reflects a misunderstanding as to what constitutes an economic cost. The numbers that appear in budget statements are not costs! The government spends by putting numbers into accounts in the banking system.
The real cost of any program is the extra real resources that the program requires for implementation. So the real cost of a Job Guarantee is the extra consunmption that the formerly unemployed workers can entertain and the extra capital etc that is required to provide equipment for the workers to use in their productive pursuits. In general, when there is persistent and high unemployment there is an abundance of real resources available which are currently unutilised or under-utilised. So in some sense, the opportunity cost of many government programs when the economy is weak is zero.
But in general, government programs have to be appraised by how they use real resources rather than in terms of the nominal $-values involved.
Accordingly, the concept of fiscal sustainability should be related to the utilisation rates of real resources, which takes us back to the initial point about the pursuit of public purpose.
Fiscal sustainability will never be associated with underutilised labour resources.
This blog aimed to bring together the last two Parts of the discussion. There is a lot of repetition across the mini-series and across all my blogs in general. You cannot say these things enough. Once government policy reflects an understanding of the things that I write about I will turn my blog into a daily surf report! I don’t plan on doing that anytime soon.
But in defining a working conceptualisation of fiscal sustainability I have avoided … as you can see … very much analysis of debt, intergenerational tax burdens and other debt-hysteria concepts used by the deficit nazis. They are largely irrelevant concepts and divert our attention from the essential nature of fiscal policy practice which is to pursue public purpose and the first place to start is to achieve and sustain full employment.