Fiscal sustainability 101 – Part 3

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.

Foreign exposure

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.

This Post Has 10 Comments

  1. Bill,

    Are you basically saying that the Central Bank buying Government bonds is an unnecessary step? The government can simply not issue debt. (Since the Central Bank and the Government, all said and done, are one unit). Instead the Cbank can pay interest on the reserves to prevent the rates from going below the target and the rate of interest for these reserves is the same as the target.

  2. Bill, one question: it the context of Australia where there is no minimum reserve requirement, what do you mean by “excess reserves”? Any reserve balances at all?

    Ramanan: if you are under the impression that the central bank does not pay interest on reserves, that is not the case in Australia nor (as of late last year) the US. In Australiia, the RBA pays target rate less 0.25% on reserve balances (known here as Exchange Settlement Accounts. Details on the interest rate currently paid on US reserves are here

  3. Sean,

    Not really – I know that they pay interest on reserves in the US. What I am asking is whether Bill means to say that the interest serves as a cushion to prevent rates from going to zero. Which is the case, really and instead I need to know if Bill means to say if that is a better alternative to not issuing bonds.

  4. Also Sean, in the Australian context, when the Government spends, it would increase the reserves by an amount fairly higher than the typical balances at the settlement account. I think Bill is talking of a general scenario when he talks of excess reserves. Paying interest on reserves is a relatively new idea and he is talking of scenarios where there can be no interest. He is telling Neoclassicals (who would not know such details) that monetization can cause rates to go to zero and would not be consistent with the Central bank’s target policy.

    I think what I have learned is that Debt monetization is impossible when there is no interest on reserves. And in cases, where there is an interest paid on reserves, monetization may not be needed. Instead, don’t issue government debt.

  5. dear Sean and Ramanan

    If you read back over my blogs – for example – Will we really be paying higher interest rates = and my academic work (it is covered in detail in my latest book) – I talk about some countries offering a support rate for overnight reserves and others do not. I noted that the RBA pays the support rate you mention while up until recently the Fed (USA) and the Bank of Japan paid nothing. In the Japanese case, this is why the overnight rate went to zero for so long. The BOJ just left enough positive bank reserves in the system to foster enough competition in the Interbank market to keep the rate at zero. Despite huge deficits!

    So the difference between the support rate (the rate paid by the central bank on overnight reserves) and the target rate becomes the “corridor” in which short-term interest rates can move depending on debt issuance. If the central bank is paying a support rate (below its target rate) then they will lose control of the target and push the system down to the support if they do not issue enough debt to drain the excess reserves.

    In recent times, the Fed, for example, has set the support rate = target rate (virtually zero) which means that they do not have to issue any debt to maintain their target. In principle, say the target is 5 per cent, the central bank could pay 5 per cent on all overnight reserves (that is, support = target) and just leave the excess reserves in the system (not drain via debt issuance) and still hold their monetary policy target.

    So then excess reserves is defined as those that do not earn the target rate – excluding those that are subject to reserve requirement rules – which in Australia were abandoned years ago as the central bank adopted the Basel Capital Adequacy approach to prudential regulation.

    Hope that clears that up.

    Ramanan’s understanding of debt monetisation is accurate. The concept can be generalised within the corridor idea mentioned above. If you want the target (> support) to persist as an expression of monetary policy then the central bank has no choice when there are budget deficits but to issue debt to drain the reserve add. It doesn’t matter whether the support rate = 0 or >0 (as long as it is < target). If support = target, then public debt issuance is unnecessary to maintain monetary policy targets.

    However, you may want to issue debt if you want the non-government sector to have less reserves (swapping bank reserves for the IOU). But none of this has anything to do with financing the government deficits spending which created the reserve add in the first place.

    best wishes

  6. Even with no corridor, I would still see a reasonable role for Government debt in central bank interest rate targeting. During the course of daily payments, there will be movements in balances between the different banks (albeit no change in the aggregate reserve balances). With interest rates on accounts with the central bank below the target rate (even only slightly as in Australia’s case) there is an incentive for those banks ending up with higher balances to lend overnight (at the target rate )back to banks who would otherwise see their balances fall below their minimum level (zero in Australia the reserve minimum in countries like the US). If the interest rate paid on central bank balances was the same as the target rate, there would be less incentive and the central bank would either have to allow overdrafts/below reserve balances or lend to the banks. If the central bank lends to a bank without security, it acquires credit exposure to the bank. This can be avoided by lending to banks on a secured basis where the security is Government debt. This is what currently happens with the the repurchase agreements that central banks use in their market operations. On top of this, Government bonds serve a useful purpose of providing benchmark interest rates for other forms of lending, not to mention a low risk investment for the public sector.

  7. Hi Bill,

    Going through the old posts 🙂

    My understanding of this logic is as follows:

    1. The government issuance of debt is a voluntary contstraint on government (agreed)

    2. If the government did not issue debt (but continued to deficit spend), then interbank overdraft rates would fall as banks would be flooded with surplus reserves, assuming loans did not grow to offset this, and the reserve requirements were unchanged. (agreed)

    3. Therefore the purpose of government debt issuance is to keep the bank overdraft rates high.

    I don’t find this argument satisfactory, because “excess” reserves are just as much a voluntary regulatory constraint as debt issuance — in fact much more so. You can increase the level of required reserves in response to government deficit spending. I have a hard time believing that we need to sell 7 trillion of debt to the non-bank private sector in order to control what are basically administratively imposed costs on banks. Just impose different administrative costs directly.

    It seems to me that you are using a nuclear bomb to kill a flea, and arguing that the purpose of nuclear bombs is to kill fleas.

    Let’s look at the other effects of the nuclear bomb:

    1. Treasuries qualify as collateral for immediate overnight cash loans by the central bank, and by extension everyone else accepts them as collateral as well. This makes them cash-equivalents, therefore they reduce the demand for cash holdings, driving down short term investor rates. Even if central banks did not accept them as collateral, they would remain highly liquid instruments because the they are claims on government.

    2. Operationally, by issuing cash-equivalent claims on government to the non-bank public, the government is creating an alternate store of value for the public other than bank deposits. It forces banks to compete with the government for the public’s cash, and this competition is healthy. Obviously in some cases increasing deposits can be inflationary, so there is an inflation fighting benefit to bonds, but that benefit can be controlled by the imposition of additional administrative requirements on banks. Nothing requires bank deposits to be more inflationary than bonds per se.

    3. The presence of a large and liquid pool of securities adds liquidity to other securities of similar maturity, because it makes it easier for investors to arbitrage, say by selling short a government claim and using the proceeds to buy other instruments, or vice versa. Without this, longer term yields would rise as it would become more expensive to arbitrage long dated securities.

    I am not saying that we should or should not issue bonds, but only that the decision to do should be to serve a public purpose — namely to allow the private sector to hold claims directly on government, to break up the monopoly power of banks in supplying cash-equivalents, and to add liquidity to the financial markets. Whether we believe this is worthwhile has nothing to do with controlling bank overdraft fees. This is a political decision, not an operational requirement of bond sales.

    The overdraft lending rates for banks is a completely separate, administrative matter. It should be set also for the public purpose by imposing the right set of flexible reserve and capital requirements; together with additional costs imposed on banks. This is completely independent of whether or not bonds are issued or how many are issued.

  8. Dear RSJ

    As usual a very measured response and a worthwhile contribution. Thanks.

    When you consider that the central bank can just pay interest on reserves anyway, the whole debt-issuance story for maintaining target rates becomes wan. As you note though there are other impacts of government paper being in the non-government sector that might (or might not) justify its continuation. In Australia, the government was pressured into continuing to issue debt even when it was running massive surpluses to appease the futures market which uses it as a risk-free pricing benchmark.

    When developing modern monetary theory it was essential to work out what situation applied once convertibility is gone. Under a convertible (gold standard or gold-standard-like) system bond-issuance clearly finances government spending which is contrained by the external parity requirements. Under a fiat monetary system, this role lapses (clearly) and so what operational purpose (not including the other impacts you note) does debt issuance serve for government. With monetary policy now setting interest rates (rather than controlling quantity) the clue has to lie in that function and the operations that support it, which by everything you write, you clearly understand. So debt-issuance supports that process in a logical sense.

    The reality is that governments around the World act as if they are still in a convertible system with the exception that exchange rates are now mostly flexible and central banks set the interest rate. But they still voluntarily adopt the “financing constraints” as an ideological position. So for them the debt-issuance is funding their net spending.

    But to understand the interest-maintenance role of debt-issuance, think about Japan from the early 1990s onwards. The BOJ knew that with the Ministry of Finance (Treasury) running huge daily budget deficits to prime aggregate demand, then it would have huge reserve adds each day. They were reluctant to leave those reserves in the system but also wanted to run a zero interest rate policy. So to console themselves that the reserves had to be drained they had to issue the debt. But they understood full well that they still had to leave some excess reserves in the system to allow the interbank competition to drive the overnight rate down to zero. So less debt was issued (from the “financing” logic) than was necessary to match daily net spending yen-for-yen. The result billions of yen of debt were issued but excess reserves stayed in the system and rates stayed at zero (or thereabouts).

    best wishes

  9. Thanks Bill,

    I enjoy all these discussions and am learning a lot.

    Perhaps one disagreement I have is that I don’t want the government to manipulate investor yields at all. This is an old post, so I hope it’s OK for me to make a long post.

    The purpose of financial markets is to price claims on profit earning capital by means of actively trading these claims. One type of capital competes with all other types of capital. This trading means that everything is discounted against overall growth prospects. These prospects are assessed across various time horizons resulting in a yield curve. This is beneficial because it allows businesses to convert the prospects of future returns into funds for investments, with mis-pricing risk fully born by investors. I.e. the private sector can fund its own investments provided that the government supplies some base liquidity in terms of cash or cash-equivalents.

    There is no public purpose served in trying to manipulate investor yields, as attempts to lower investor yields are really attempts to subsidize for-profit businesses by lowering their funding costs. Instead, government should interpret these price signals as one of the inputs into its fiscal decisions to promote steady growth. Government can focus on social spending and developing public goods, and then for-profit businesses should compete for this augmented demand, being only indirectly funded by government. The rationale of boosting investment by subsidizing investors is not necessary.

    The purpose of bank lending is to grant credit based on the ability to repay the loan. For investment banks that loan to for-profit entities that have access to the credit markets, this means earning money from the spread between long and short term rates. In this case banks are just another player in the private sector credit markets, and therefore should not have lower funding costs, should not be able to accept household deposits, should not have their debt guaranteed, should not receive government backing, or have access to government overdraft facilities. These are pure investment banks that live and die on the success of their spread bets.

    In times of a real liquidity crisis or settlement failures, the government should step in to provide liquidity to all participants in the credit markets that hold good collateral, without preference to investment banks, but the government should not intervene in anyone’s day to day funding costs. This is because for-profit businesses should only be able to bid away goods from other for profit businesses if they can offer a better return; there is no social benefit to subsidizing yield spread bets as opposed to any other type of credit market bet.

    There is a social benefit to granting cash-flow management services to households, non-profits, and small businesses that cannot access the private sector credit markets. These borrowers should not be forced to compete with IBM for funding, or with each other. Therefore government-backed banks are allowed to use extreme leverage and access government overdraft facilities. Their cost of funds are shielded from the market and are set administratively. This is to ensure that everyone that qualifies for a loan is funded, and the real rate demanded is hopefully both low and constant regardless of what is happening in the capital markets. Attempts to lower these borrowing costs during recessions is an abdication of government’s deficit spending requirements, and promotes household indebtedness and income inequality. Attempts to boost these rates for purposes of inflation fighting is an admission that the government let broad money increase too quickly, meaning that capital requirements and underwriting standards failed. In this case, the underwriting standards and capital requirements should be fixed before raising the rate. The pain of inflation fighting should not be unduly shifted to these small-time borrowers; rather borrowers in the credit markets should bear the bulk of these costs as yields are pushed higher during periods of inflation volatility.

    But to the degree that the government-set rate “leaks” into the investor yield curve, the banks will abandon their charter of underwriting costly small loans and turn to playing spread games in the financial markets. With their enormous leverage and government backing, they will shift investor capital away from income-earning projects and towards projects that meet bank lending requirements — generally non-productive real estate. Therefore the channel by which FedFunds affects short term rates is just bank subsidies and misallocating capital. The consequences of rate targeting, since it began in the early late 1980s include the growing compensation of bankers, the growing share of GDP allocated to finance, the shrinking share of investments in productive enterprises, and growing number of college graduates choosing to work in finance.

    That is a heavy price to pay in exchange for being able to control short term investor rates. And you will not be able to control these rates without paying a similar price in the future. Only by subsidizing investors can you push down investor rates.

    A hidden consequence is that the favored participants become more powerful and block reform when the crisis comes.

    This brings us to Japan. I think the excess reserves and low yields are just what happens during a lending collapse. Look at the long depression of 1873-1894: call money rates at first spiked from about 5.5% in 1871 to 14.2% during the liquidity crisis stage in 1873 — many banks failed. But the next year call rates fell to 3.4% and eventually hit 1% in 1894. Long Term New England municipal yields fell from 5.5% to the low 3% in 1894. You can measure excess reserves by looking at the NBER index measuring the ratio of loans and discounts to deposits, which peaked at 180 in 1870 and then fell quickly to about 120 by 1881, and then remained at that level until 1894. These measures follow a similar pattern to what we saw in Japan or in the Great Depression.

    In all cases, private sector de-leveraging then proceeded for over a decade, resulting in a depressed economic environment. When people are paying down debt and do not want to borrow, then reserves become excess and yields fall even without any fiscal spending and on a gold standard. If anything, the experience of Japan shows that while deficit spending certainly had an important palliative effect, the economy as a whole did not succeed in escaping the common deflationary pressures in these other episodes.

    Falling rates make it hard for banks to recapitalize. In a fiat system, loan losses can be hidden as more cash is added, which creates additional upward pressures on surplus reserves. At the same time, only fiscal spending in excess of de-leveraging has a non-zero multiplier effect, but unless this fiscal spending results in huge wage boosts, the de-leveraging will drag down growth for many years. If it takes 30 years to pay off a mortgage, then a 50% drop in house prices requires a long period of demand gaps that all must be made up for by fiscal spending. The result leaves borrowers traumatized. As expectations of low nominal returns take root, long term yields fall and investments are scaled back, requiring even more fiscal spending. The huge fiscal spending boosts required fundamentally alter the economy, as more investment capital is allocated politically. Certainly fiscal spending is necessary to counter the ebbs and flows of the business cycle, but when you are faced with a 20 year de-leveraging cycle, you need to attack the root of the problem, which is balance sheets.

    Suppose that at the start of the crisis, the Japanese government would have placed the banks into receivership, immediately guaranteed deposits, and zeroed out bank capital. If the required capital ratio was, say 12:1, then the government forgives 8% of the loans and grants this as equity to the owners. This means zero net-worth loss to aggregate private sector balance sheets, just a shift in wealth from bank investors to debtors. Then the government announces that 40% of the loans would be converted to tax obligations on resale, subordinate to the equity and debt. The obligations remain on the property, not on the borrower, and are slowly diminished each year. No change in net-worth, but instantly debt is cut almost in half. In contrast, Japanese households have suffered for 15 grinding years, managing to de-lever by 30%. This could have been done in a weekend without any Kabuki plays in which the government builds bridges so that households can de-lever.

    In our ideal scenario, the banks now have a huge capital hole. The government capitalizes the banks with long term debt to fill this hole. It promises to require no interest payments until the economy improves, and that subsequently the rates would be set in a manner to promote prudent lending. This becomes your new call rate. Then government can unleash a flood of fiscal spending, and there are no excess reserves, as the bank debt is the sink for government spending. Government does not need to pay banks any interest or borrow during the crisis. Because there is little de-leveraging drag, the economy will improve much more quickly, and the stimulus portion of deficit spending is more temporary. Because banks are owned by government, they will lend. When the economy improves, the banks are auctioned off to the private sector and households are willing to hold deposits in them.

    So the typical solutions: lower rates, increase excess reserves, fund the banks, and attempt to boost asset prices are the exact opposite of what should be done, IMO. This is not a liquidity crisis, but a balance sheet crisis, and you cannot rely just on deficit spending. But all this requires that you seize the opportunity and nationalize banks when you have a window of opportunity — during the liquidity crisis stage when legally they are insolvent and can be seized. If fiat powers are used to bail out the banks during the liquidity crisis stage and just tied households over with one stimulus boost after another, you prevent the quick balance sheet adjustment from occurring, and are doomed to long periods of low growth.

    At least, that is my current thinking 🙂

  10. Hi, All-

    This is a key post in the sequence, and I hoped that it would address a key constraint on fiscal policy more directly- inflation. Does the debt level have any bearing on inflation? It does not seem that way from the discussions here. Debt corresponds to someone’s savings, and if they prefer wealth accumulation to consumption, that is no business of the government. … Unless these preferences are subject to rapid change, but then the 28 trillion in private debt (in the US) is equally or more volatile.

    But the deficit position seems more relevant, as is the money spent on debt servicing. This interest is not different from other government spending.. it all comes from the same pot. So if fiscal policy needs to contract during a boom cycle, it would be nice not to be saddled with what amounts to involuntary spending on past debt. Current fiscal flexibility is reduced in proportion to how much of the budget is devoted to interest payments on debt, which are in effect a redistribution scheme, usually supporting the wealthy.

    If fiscal policy is being used to regulate inflation/deflation, then the relation between deficits and inflation seems pretty critical. Specifically, if inflation rises, but the unemployment rate is still higher than desired, then what? It would seem that inflation should take precedence in general terms. This could happen from resource shocks, or from defects in the theory that productive capacity reaches 100% level uniformly through the economy at the same time before any inflation is possible .. which does not seem realistic.

    If fiscal policy is subordinate to monetary policy, as is the usual case, then debt, as you say, is all handled by the Fed as a monetary operation, at its preferred interest rate. But where did that rate come from? It came from the inflation data. So if the monetary arm and the fiscal arm are not aligned, the one could be creating inflation that the other is trying to douse with higher rates and expensive debt.

    Thanks.. I guess I am trying to say that inflation needs to be more explicitly treated when dealing with deficit terrorists, since that is the ultimate constraint on the MMT theory, after it has disposed of constraints like loanable funds, tax-funded spending, etc.

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