Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
At the London event last week, I indicated that governments should not issue any public debt as the benefits of doing so are small relative to the large opportunity costs. The Modern Monetary Theory (MMT) position is that there is no particular necessity to match public deficits with debt-issuance for a currency-issuing government and deficits should be accompanied by monetary operations which we now call Overt Monetary Financing (OMF). Surprisingly there was some arguments by audience members that governments should continue to issue debt, largely, as I understand them, to provide a safe haven for workers to save for the future. So the idea is that we maintain the elaborate machinery that is associated with the public debt issuance just to provide a risk free asset that workers can use to park their hard-earned savings in. It is a strange argument given the massive opportunity costs associated with debt issuance. A far simpler solution is to exploit the currency-issuing capacity of the government to guarantee a publicly-owned National Saving Fund. No debt would be required.
We start with Abba Lerner’s Functional Finance, which represents a major influence on the development of what we call MMT. He provided guidance on when governments should issue debt.
Lerner sought to explain that it is the responsibility of the currency-issuing government to ensure that total spending in the economy is maintained at a level consistent with full employment.
It does that by altering its spending and taxation policies to generate enough sales that with current productivity levels would provide jobs for all those who want to work.
He also knew that more often than not fulfilling those responsibilities will result in fiscal deficits and that there was nothing “bad about this”.
In his 1943 article – Functional Finance and Federal Debt – Abba Lerner said:
The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound or unsound. This principle of judging only by effects has been applied in many other fields of human activity, where it is known as the method of science opposed to scholasticism. The principle of judging fiscal measures by the way they work or function in the economy we may call Functional Finance …
Government should adjust its rates of expenditure and taxation such that total spending in the economy is neither more nor less than that which is sufficient to purchase the full employment level of output at current prices. If this means there is a deficit, greater borrowing, “printing money,” etc., then these things in themselves are neither good nor bad, they are simply the means to the desired ends of full employment and price stability …
[Reference: Lerner, A. (1943) ‘Functional Finance and the Federal Debt’, Social Research, 10(1), 38-51].
The focus on government should not be on the deficits but on the prosperity and inclusion that full employment delivers.
He also understood that people are “easily frightened by fairy tales of terrible consequences” when new ideas are presented.
The sense of fright is driven by a lack of education that leaves people unable to comprehend how the economy actually operates.
Neo-liberals magnify that sense of fright, by demonising what are otherwise sensible and viable explanations of economic matters.
They know that by elevating these ideas into the domain of fear and taboo, they increase the probability that political acceptance of the ideas will not be forthcoming.
That strategy advances their ideological agenda. The basic rules that should guide government fiscal policy are, as Lerner noted, “extremely simple” and “it is this simplicity which makes the public suspect it as too slick).
Neo-liberals who have vested interests in ensuring that the public does not understand the true options available to a government that issues its own currency manipulate that suspicion.
In the place of these simple truths, neo-liberals advance a sequence of myths and metaphors that they know will resonate with the public and become the ‘reality’.
So what did Lerner say about debt issuance?
In the context of governments maintaining “a reasonable level of demand at all times” and maintain interest rates that “induces the optimum amount of investment”.
In this Biography of Lerner you read the following (pages 218-19):
In 1943 Lerner published an article, “Functional Finance and the Federal Debt,” that announced a new approach to fiscal policy. (The subject was further developed in his Economics of Control and the Economics of Employment.) He noted that conventional fiscal wisdom was based on the principles and morals of good household management: don’t spend what you don’t have – a tacit reminder that the words “economy” and “economics” are etymologically derived from oikos, the Greek word for household.
Lerner, however, picking up on the summary Keynesian prescription of deficit spending, argued that governments should not be concerned with conventional morality but rather should consider only the results of their actions. The aim of government spending and taxing, he said, should be to hold the economy’s total spending at a level compatible with and conducive to full employment at current prices – in other words, no unemployment and no inflation. In doing this the government should not be concerned with deficits or debt. Second, the government should borrow or repay only insofar as it wants to change the proportions in which the public holds securities or money. Changing this proportion will raise or lower interest rates and hence discourage or promote investment and credit purchasing. If the only question, then, was how to finance a deficit, Lerner advocated printing money. Third, the government should put money into circulation or withdraw (and destroy) it as needed to effect the results called for by the first two principles.
So the only reason a government should issue debt is if it wanted to alter the “proportions in which the public holds securities or money”. It is clearly recognised that the government does not need to raise revenue.
In his 1943 article Lerner says (page 355) that the government would only issue debt “if otherwise the rate of interest would be too low”. So you start to understand that the “borrowing” is a monetary operation not a funding necessity.
He went further on this theme in his 1951 book when he says (pages 10-11) that the:
… spending of money … out of deficits keeps on increasing the stock of money (and bank reserves) and this keeps on pushing down the rate of interest. Somehow the government must prevent the rate of interest from being pushed down by the additions to the stock of money coming from its own expenditures … There is an obvious way of doing this. The government can borrow back the money it is spending (emphasis in original).
This is one of the fundamental insights of MMT – that debt issuance can assist the central bank to drain excess bank reserves that were generated by the net spending (deficits) in the first place.
That was the topic of yesterday’s blog.
The government just borrows its own spending back. If it didn’t do that and if the central bank didn’t pay a return on overnight reserves then the interest rate would fall to zero (or some support rate that the central bank did pay).
And for those progressives (the deficit-doves) – the “proponents of organized prosperity”, Lerner had this to say in his 1951 book (page 15).
A kind of timidity makes them shrink from saying anything that might shock the respectable upholders of traditional doctrine and tempts them to disguise the new doctrine so that it might be easily mistaken for the old. This does not help much, for they are soon found out, and it hinders them because, in endeavoring to make the new doctrine appear harmless in the eyes of the upholders of tradition, they often damage their case. Thus instead of saying that the size of the national debt is of no great concern … [and] … that the budget may have to be unbalanced and that this is insignificant when compared with the attainment of prosperity, it is proposed to disguise an unbalanced budget (and therefore the size of the national debt) by having an elaborate system of annual, cyclical, capital, and other special budgets.
MMT suggests that the policy interest rate should be maintained at zero, which means there is no need to have stocks of public debt in the hands of the non-government sector.
So why issue public debt at all?
Even if one adopts a fundamentally ‘market oriented’ approach there is no compelling case to issue public debt.
Some markets, including the labour market, exhibit cyclical asymmetries and high degrees of persistence following negative shocks that are so costly in terms of foregone output and employment that government intervention is compelling.
However, financial markets in general, allowed to operate within appropriate regulatory frameworks, are much closer to the parameters outlined in competitive theory and can generate reasonably efficient outcomes without direct government interference.
Government intervention into private markets is a serious matter and must be justified with a proper cost-benefit analysis.
Financial stability is a public good
The current financial system is linked to the real economy via its credit provision role. Both households and business firms benefit from stable access to credit.
To achieve financial stability: (a) the key financial institutions must be stable and engender confidence that they can meet their contractual obligations without interruption or external assistance; and (b) the key markets are stable and support transactions at prices that reflect fundamental forces.
There should be no major short-term fluctuations when there have been no change in fundamentals.
Financial stability requires levels of price movement volatility that do not cause widespread economic damage. Prices can and should move to reflect changes in economic fundamentals.
Financial instability arises when asset prices significantly depart from levels dictated by economic fundamentals and damage the real sector.
Collapses brought on by injudicious speculation that do not affect the real sector or that can be insulated from the real sector by appropriate liquidity provisions are not problematic.
The essential requirements of a stable financial system are:
1. Clearly defined property rights;
2. Central bank oversight of the payments system;
3. Capital adequacy standards for financial institutions;
4. Bank depositor protection;
5. An institutional lender-of-last resort when private institutions refuse to lend to solvent borrowers in times of liquidity crisis;
6. An institution to ameliorate coordination failure among private investors/creditors;
7. The provision of exit strategies to insolvent institutions.
While some of these requirements can be provided by private institutions, all fall in the domain of government and its designated agents.
However, none of these requirements rely on the existence of a viable government bonds market.
Private goods are traded in markets where buyers and sellers exchange at prices that reflect the margin of their respective interests.
At the agreed price, ownership of the good or service transfers from the seller to the buyer.
A private good is ‘excludable’ (others cannot enjoy the consumption of it without being party to the transaction) and ‘rival’ (consuming the good or service specific to the transaction, denies other potential consumers its use).
Alternatively, a public good is non-excludable and non-rival in consumption. Private markets fail to provide socially optimal quantities of public goods because there is no private incentive to produce or to purchase them (the free rider problem).
To ensure socially optimal provision, public goods must be produced or arranged by collective action or by government.
We conclude that financial system stability meets the definition of a public good and is the legitimate responsibility of government.
What are the alleged benefits of public debt issuance
Most of the arguments made in favour of sustaining public debt issuance can be reduced to special pleading by an industry sector for public assistance in the form of risk-free government bonds for investors as well as opportunities for trading profits, commissions, management fees, and consulting service and research fees.
It is ironic that these arguments are inconsistent with rhetoric forthcoming from the same financial sector interests in general about the urgency for less government intervention, more privatisation, more general welfare cutbacks, and the deregulation of markets in general, including various utilities and labour markets.
Specifically, government price level intervention into private markets is typically challenged by economists on efficiency grounds.
Public debt issuance is a form of government price level intervention in interest rate markets.
The burden of proof falls on those arguing in favour of such issuance to show that the market in question is incapable of viable operation without government intervention and will, unassisted, produce outcomes detrimental to the macro priorities we discussed earlier – full employment etc.
Pricing other products
One argument mounted to support public debt issuance is that it supports the yield curve and is used by financial markets as the benchmark risk free asset, which provides a benchmark for pricing any other debt security.
There are clearly alternatives:
1. The market could price securities against other securities with similar characteristics.
2. Market participants could price securities with respect to the interest rate swap curve.
Market participants already use the interest rate swap curve to price securities. Regardless, the term interest rate structure remains a meeting of supply and demand. Buyers and sellers of bonds desire to attract each other and meet at a price.
Are the proponents of retaining public debt issuance really claiming that without government intervention in the credit markets via such issuance borrowers and investors cannot sufficiently come together at a price?
Are they saying that the interest rate market does not have sufficient levels participation, information and competition to adequately determine price without government intervention?
It is doubtful that either position can be substantiated, and certainly not to the degree needed to support the issuance of public debt with their high real macro costs which I will outline below.
Managing financial risk
Another argument is that on-going public debt issuance supports a number of derivative markets that help private traders manage financial risk, particularly in relation to interest rate risk.
What are their real interest rate risks of these businesses? What are the real economic costs of these feared changes?
Without going into detail, it is important to ask which businesses ‘need’ to use public debt to manage risk. The reality is that it on-going public debt issuance supports and encourages speculation, rather than real investment behaviour.
Some financial market speculation (which is tied to helping real output producing firms off-load exchange rate risk, for example) is sound. But that is a tiny proportion of the financial market transactions that occur each day.
So can the support of particular businesses in this manner which add nothing to the well-being of the population be an appropriate use of public policy?
It is in this context that I use the term corporate welfare in association with the issuance of public debt.
It should also be understood that MMT advocates the simplification of financial markets and the phased elimination of speculative behaviour that provides no real benefits to the population.
Providing a long term investment vehicle
This argument was raised on Thursday night in London. The crude argument is that workers have a right to expect their savings will be held in risk-free assets and that public debt issuance provides those assets.
It is a simplistic argument and while I am supportive of workers being able to save (risk manage their futures) in a safe way, that doesn’t justify the massive corporate welfare that accompanies the issuance of public debt.
More specifically, it is argued if superannuation and life companies were unable to purchase government debt then they would struggle to match their long-dated liabilities with appropriate returning assets.
Further, the claim is that eliminating the government bonds market would deny workers of a risk free, $A denominated asset to invest there savings in. Retirement planning would become highly uncertain and risky.
What is not often understood is that government bonds are in fact government annuities.
Do the proponents of on-going government bonds really want the private sector to have access to government annuities rather than be directing real investment via privately-issued corporate debt, as an example?
This point is also applicable to claims that government bonds facilitate portfolio diversification. Why would we want to provide government annuities to private profit-seeking investors?
This interferes with the investment function of markets, and that direct government payments be limited to the support of private sector agents when failures in private markets jeopardise real sector output (employment) and price stability.
We would also require a comparison of this method of retirement subsidy against more direct methods involving more generous public health and welfare provision and pension support.
But there is a much more effective way to provide a risk-free savings vehicle for workers. The government could create a National Savings Fund, fully guaranteed by the currency-issuing capacity of the government, which could provide competitive returns on savings lodged with the fund.
There would be no public debt issuance (and the associated corporate welfare and government debt management machinery) required.
The government could meet any nominal liabilities at any time.
Providing a safe haven
Government securities are alleged to provide a ‘safe haven’ for investors when there is financial instability.
The ‘flight to quality’ argument suggests that it is beneficial to the macro economy for investors to have a risk free domestic asset available to avoid capital losses on other assets.
However, in addition to the previous point regarding subsidy through government annuities, government bonds compete directly with these other assets, thereby driving down their prices and exacerbating matters during ‘flights to quality’.
In a monetary economy, investors can always hold money balances by increasing actual cash holdings or banking system deposits.
Widespread use of deposit insurance would mean that bank deposits would be equivalent to holding government bonds anyway for all practical purposes.
That also passes the ‘risk’ to private banks when they select their assets and selection of assets is regulated by the central bank.
There is no compelling real macroeconomic reason why risk and return decisions by private maximising agents should be ‘further protected’ by retreat to a market distorting government annuity.
Further, during a ‘flight to quality’ only the relative prices of various fixed income securities can change, not the quantity, as investors compete for the existing stock of outstanding government debt.
At the macro level, this process does not reduce risk.
Implementing monetary policy
We have already learned from yesterday’s blog that the central bank can maintain any interest rate policy target it desires through the use of a support rate on excess reserves.
It requires no public debt in this regard.
There are many other arguments that are put forward to justify the ongoing issuance of public debt. All of them can be reduced to special pleading by speculators for risk free assets.
What are the real economic costs involved in issuing government debt?
The real economic costs involved in issuing government debt
The real costs of any resource-using activity are measured by the opportunity costs of not using these resources in alternative activities.
The operation of public debt markets absorb a diversity of real resources deployable elsewhere.
While this is difficult to assess in the context of an economy without public debt markets, some points can be made to structure our thinking.
The opportunity costs in terms of the labour employed directly and indirectly in the public debt ‘industry’ are both real and large.
The ‘cottage industry firms’ that characterise the public debt industry use resources for public debt issuance, trading, financial engineering, sales, management, systems technology, accounting, legal, and other related support functions.
These activities engage some of the brightest graduates from our educational system and the high salaries on offer lure them away from other areas such as scientific and social research, medicine, and engineering.
It could be argued that the national benefit would be better served if this labour was involved in these alternative activities.
Government support of what are essentially distributional (wealth shuffling) activities allows the public debt market to offer attractive salaries and distorts the allocation system.
While this labour may move within the finance sector if public debt issuance terminated, the Government could generate attractive opportunities by restoring its commitment to adequate funding levels for research in our educational institutions.
On balance, public debt markets appear to serve minor functions at best and the interest rate support can be achieved simply via the central bank maintainng current support rate policy without negative financial consequences.
The public debt markets add less value to national prosperity than their opportunity costs. A proper cost-benefit analysis would conclude that the market should be terminated.
This blog was drawn, in part, from an edited version of a submission that I made with Warren Mosler in 2001 to the Commonwealth Debt Inquiry, which sought to justify why the government should continue to issue debt when it was in fact running increasing surpluses.
That is enough for today!
(c) Copyright 2015 William Mitchell. All Rights Reserved.