I read an article in the Financial Times earlier this week (September 23, 2023) -…
Saturday morning traditions … a long early ride on my bike (70 odd kms), then off to the local cafe for a cup of tea. Yes, time to read an actual paper paper. Time to talk about the state of the swell and wind direction (off-shore and pumping at present). The big match (Saints v Geelong, both unbeaten after 13 rounds – note no rugby here!). Perhaps some local gossip (who paid off who to get what development up!) … that sort of thing. Probably some politics. But no, before anything interesting could be raised by the assembled regulars … someone (a non-economist who claims he is just interested) had to begin proceedings with “Bill, why does the federal government borrow when you say it does not have too?” Can you put a sock in it, please! What about the surf? But why if they don’t have too? Saturday morning … the problem of being a macro economist. Things started getting ugly at this point.
Okay, first we have to go back to … the Gold Standard … yawn.
Under the Gold Standard, the leading economies of the world through their monetary authorities agreed to maintain the “mint price” of gold fixed by standing ready to buy or sell gold to meet any supply or demand imbalance. Further, the central bank (or equivalent in those days) had to maintain stores of gold sufficient to back the circulating currency (at the agreed convertibility rate). The currency was strictly convertible into gold at the fixed parity. So this was a convertible, fixed exchange rate system.
Gold was also considered to be the principle method of making international payments. Accordingly, as trade unfolded, imbalances in trade (imports and exports) arose and this necessitated that gold be transferred between nations (in boats) to fund these imbalances. Trade deficit countries had to ship gold to trade surplus countries. This inflow of gold into surplus countries allowed them to expand their money supply (issue more notes) because they had more gold to back the currency. This expansion was in strict proportion to the gold-currency parity. The rising money supply would push against the inflation barrier (given no increase in the real capacity of the economy) which would ultimately render exports less attractive to foreigners and the external deficit would decline. The trade deficit country would lose gold reserves and this would force their government to withdraw paper currency which drove up unemployment and drove down the price level. The latter improved the competitiveness of that economy. The two adjustments – for the surplus and deficit countries helped to resolve the trade imbalance. But it remains that the deficit nations were forced to bear rising unemployment and vice versa as the trade imbalances resolved.
So under the Gold Standard, the government could not expand base money if the economy was in trade deficit. It was considered that this constraint acted as a means to control the money supply and generate price levels in different trading countries which were consistent with trade balances. The domestic economy however was forced to make the adjustments to the trade imbalances. Monetary policy became captive to the amount of gold that a country possessed (principally derived from trade).
In practical terms, the adjustments to trade that were necessary to resolve imbalances were slow. In the meantime, deficit nations had to endure domestic recessions and entrenched unemployment. So a gold standard introduces a recessionary bias to economies with the burden always falling on countries with weaker currencies (typically as a consequence of trade deficits). This inflexibility prevented governments from introducing policies that generated the best outcomes for their domestic economies (high employment). Ultimately the monetary authority would not be able to resist the demands of the population for higher employment.
Significantly, the fixed exchange rate system restricted the capacity of fiscal policy because monetary policy had to target the exchange parity. If the exchange rate was under attack then the central bank had to intervene to defend the parity. So if fiscal policy was used too aggressively to reduce unemployment, it would invoke a monetary contraction. Ultimately, the primacy of monetary policy ruled because countries were bound to maintain the exchange rate parities. They could revalue or devalue (once off realignments) but this was frowned upon and not common. Whichever version of the Gold Standard we want to talk off – pure gold standard or USD-convertible system backed by gold (which came later) – the constraints on government were obvious.
Existing gold reserves controlled the domestic money supply and restricted the expansion of bank reserves and the supply of high powered money (Government currency). The central bank thus could not expand their liabilities beyond their gold reserves (although it is a bit more complex than that). In operational terms this means that once the threshold was reached, then the monetary authority could not buy any government debt or provide loans to its member banks.
Further, the national government could only increase the money supply by acquiring more gold. Any other expenditure that the government makes would have to be “financed” by taxation or by debt issuance. The government cannot just credit a commercial bank account under this system to expand its net spending independent of its source of finance. As a consequence, whenever the government spent it would require offsetting revenue in the form of taxes or borrowed funds.
[BACK TO THE CAFE]
“Okay”, said the troublemaker who started this conversation in the first place.
“So that is clearly a technical constraint on fiscal policy”.
“And it was voluntary, wasn’t it?”
“Totally voluntary. Any government could have broken out of it – with political difficulties given the trade sector was so interwoven”.
“But the Gold Standard, or USD-convertibility collapsed in the early 1970s when Bretton-Woods was abandoned.”
“Yes” (note my monosyllabic answers to get end the conversation quickly)
[The Ted Theodore nut in the group was starting up!]
Relief, I thought. What followed was a monologue from one of the cafe regulars who is researching the constraints on full employment that have been imposed through history. The conversation outlined how the colonial relationship with the Britain forced state governments in Australia during the 1920s to borrow from financiers in Britain. These characters reacted harshly when the colonial governments (Labour) attempted to introduce legislation providing employment guarantees. I might get this character to write a guest blog here because the story is fascinating and murky indeed.
[BACK TO THE CAFE]
“Okay, all that is interesting … but what about the original question?”
[Trouble makers just don’t know when to shut up. I thought my boring treatment of the Gold Standard would have exhausted the assembled company’s desire to discuss macroeconomics on a Saturday morning – but I was wrong]
Okay, so now we have a fiat monetary system. The move to fiat currencies fundamentally altered the way the monetary system operated. This system had two defining characteristics: (a) non-convertibility; and (b) flexible exchange rates.
Combined they meant that the national government was sovereign in its own currency which means that it is no longer revenue-constrained. It can spend however much it likes subject to there being real goods and services available for sale. Irrespective of whether the government has been spending more than revenue (taxation and bond sales) or less, on any particular day the government has the same capacity to spend as it did yesterday. There is no such concept of the government being “out of money” or not being able to afford to fund a program. How much the national government spends is entirely of its own choosing. There are no financial restrictions on this capacity.
[BACK TO THE CAFE]
“So why do they borrow?”
[Just won’t shut up]
Well there are several reasons – some technical and others ideological.
First, in technical sense, when there are deficits bank reserves are growing and banks will try to get rid of these reserves by lending them on the overnight interbank market. The competition for funds drives the interest rate down to whatever support rate the central bank pays on overnight reserves. The problem is that the banks cannot eliminate the system-wide reserve surplus created by the deficits. If the system is left alone the central bank will lose control of its target interest rate. There are two things the government can do to retain control over its monetary policy stance. It can offer an interest-bearing asset in place of the reserves – that is, sell the banks government bonds (that is, “borrow”) or it can pay the target interest rate on overnight reserves. The second option is currently being used in the US for example.
Second, the overwhelming sentiment of the business community and the conservative nature of our political system (and its participants) leads to a largely anti-government swell of opinion which is continually reinforced by the media – the “debt-deficit hysterics”. The neo-liberal expression of this over the last three decades has overwhelmingly imposed massive political restrictions on the ability of the government to use its fiscal policy powers under a fiat monetary system to ensure we have full employment. We now accept very high unemployment and underemployment rates as a more or less permanent feature of our economic lives because of the political constraints imposed on government.
So while there was a major shift in history after the collapse of Bretton Woods, the logic that applied in the fixed exchange rate-convertibility days is still being imposed despite the economic fact that it does not apply in the fiat currency era.
[BACK TO THE CAFE]
“So the government imposes voluntary constraints on itself for political reasons?”
The neo-liberal macroeconomic reasoning that you read about in the newspapers is really the sort of reasoning that prevailed in the days prior to fiat currency. The shift in history renders most of the textbook economics outdated and wrong, in terms of how they depict the operations of the fiat monetary system.
To see how this ideology works you just have to examine the establishment of the Australian Office of Financial Management, which was set up as a special part of the Federal Treasury to management federal debt. While there was a lot of hoopla about it being an “independent agency”, the reality is that this is all largely cosmetic – it is still part of the consolidated government.
Prior to this bond issues were made using the “tap system”. The government would announce some face value and coupon rate at which it would issue debt and “turn the tap on hard enough” to meet the demand at that yield. Occasionally, given other rates of return in the financial markets the issue would not be fully subscribed – meaning some of the net spending would be covered in an accounting sense by central bank buying treasury bills (government lending to itself!).
This system was highly criticised by the growing “neo-liberal squawk squad” who claimed it was:
breaching what is today regarded as a central tenet of government financing – that the government fully fund itself in the market. It then became the central bank’s task to operate in the market to offset the obvious inflationary consequences of this form of financing, muddying the waters between monetary policy and debt management operations.
This statement was made by the Deputy Chief Executive Officer of AOFM in 2000 to justify his salary!
But you get the drift. As to the central tenet – this is pure ideology and has no foundation in economic theory. It is a political statement. But the impact was to constrain the government from creating full employment, which the conservatives hated because it threatened to redistribute more of the national income toward labour. Since the 1980s as governments maintained high rates of labour underutilisation under pressure to do so from the business lobby, the profit share in national income has burgeoned.
Further, there is an automatic assumption drawn from neo-liberal doctrine that budget deficits are inflationary and have to be funded. The former statement is not necessarily true (it might be true under special circumstances that have not applied for a long time) and the latter statement about funding is untrue – categorically.
Anyway, the Federal government introduced some really stupid reforms to the way government bond markets operated. All these policy choices and changes to the “operations” of the bond markets were voluntary choices by the Government based on ideology. There is nothing essential about the changes. Further, they are largely cosmetic.
They replaced the tap system with an auction model to eliminate the alleged possibility of a “funding shortfall”. Accordingly, the system now ensures that that all net government spending is matched $-for-$ by borrowing from the private market. So net spending appeared to be “fully funded” (in the erroneous neo-liberal terminology) by the market. But in fact, all that was happening was that the Government was coincidently draining the same amount from reserves as it was adding to the banks each day and swapping cash in reserves for government paper. The bond drain meant that competition in the interbank market to get rid of the excess reserves would not drive the interest rate down.
The auction model merely supplied the required volume of government paper at whatever price was bid in the market. So there was never any shortfall of bids because obviously the auction would drive the price (returns) up so that the desired holdings of bonds by the private sector increased accordingly. As an aside, at that point the secondary bond market started to boom because institutions now saw they could create derivatives from these assets etc. The slippery slope was beginning to be built.
But you see the ideology behind the decision by examining the documentation of the day. This quote is from a speech from the Deputy Chief Executive Officer of AOFM. He is talking about the so-called captive arrangements, where financial institutions were required under prudential regulations to hold certain proportions of their reserves in the form of government bonds as a liquidity haven.
… the arrangements also ensured a continued demand from growing financial institutions for government securities and doubtless assisted the authorities to issue government bonds at lower interest rates than would otherwise have been the case … Because such arrangements provide governments with the scope to raise funds comparatively cheaply, an important fiscal discipline is removed and governments may be encouraged to be less careful in their spending decisions.
So you see the ideological slant. They wanted to change the system to voluntary limit what the Federal government could do in terms of fiscal policy. This was the period in which full employment was abandoned and the national government started to divest itself of its responsibilities to regulate and stimulate economic activity.
And in case you aren’t convinced, here is more from AOFM:
The reduced fiscal discipline associated with a government having a capacity to raise cheap funds from the central bank, the likely inflationary consequences of this form of ‘official sector’ funding … It is with good reason that it is now widely accepted that sound financial management requires that the two activities are kept separate.
Read it over: reduced fiscal discipline … that was the driving force. They were aiming to wind back the government and so they wanted to impose as many voluntary constraints on its operations as they could think off. All basically unnecessary (because there is no financing requirement), many largely cosmetic (the creation of the AOFM) and all easily able to be sold to us suckers by neo-liberal spin doctors as reflecting … read it again … “sound financial management”.
What this allowed was the relentless campaign by conservatives, still being fought, against the legitimate and responsible use of budget deficits. What this led to was the abandonment of full employment.
[BACK TO THE CAFE]
“What about Latvia? Didn’t they just fail to sell their government bonds recently?”
[Another person who spends too much time reading the financial news]
“Yes” [monosyllabic answer]
“But doesn’t that mean their economy has collapsed?”
“Because they issue their own currency unlike their Eurozone neighbours. The government spending is still going on. No-one is having to give back their welfare cheques or give back payments for goods and services they supplied to the Latvian government.”
“How can they spend then if the financial markets won’t buy their debt.”
“They just credit bank accounts as always whether they drain the reserves with bond issues or not.”
“So they print money and so there will be inflation.”
“Someone prints currency notes in Latvia but that hasn’t the slightest relationship to government spending. Government spend by crediting bank accounts.”
Anyway, I am planning to write a blog about Latvia because it is quite interesting. The pressures their government is now under to go to the IMF are huge. They should resist and default on all their international debt. But that is another story.
[Then someone decided to push the discussion a bit]
[BACK TO THE CAFE]
“If governments issue debt for reasons not related to financing then it would be interesting if you could find a time when they borrowed but were running surpluses!”
“Funny you raise that. There is another reason governments issue debt ….”
[Despite my protestations … macroeconomics on a Saturday is still of some interest, isn’t it?]
In December 2002, the Australian Treasury conducted a review to consider “the issues raised by the significant reduction in Commonwealth general government net debt for the viability of the Commonwealth Government Securities (CGS) market”.
You can download our Submission (written by my mate Warren Mosler and me) and you can download the Treasury (2002) Review Of The Commonwealth Government Securities Market, Discussion Paper, Commonwealth of Australia, October.
The Federal Government was running huge surpluses by this time and clearly did not need in terms of “neo-liberal” logic to issue debt to “fund” anything. The Treasury Discussion Paper (Page 2) gave the game away by claiming that purported CGS benefits include:
assisting the pricing and referencing of financial products; facilitating management of financial risk; providing a long-term investment vehicle; assisting the implementation of monetary policy; providing a safe haven in times of financial instability; attracting foreign capital inflow; and promoting Australia as a global financial centre.
The SFE’s Submission considered these functions to be equivalent to public goods.
The reality of the day was that the Sydney Futures Exchange (SFE) went ballistic as the bond market starting thinning due to the government retiring its debt (ideological obsession with “getting the debt monkey off our backs” – which was tantamount to destroying private wealth and income streams and forcing the non-government sector to become increasingly indebted to maintain spending growth).
The public good argument has to be distinguished from argument tantamount to special pleading for sectional interests. Private markets under-produce public goods. When economic activity provides benefits beyond the space defined by the immediate ‘private’ transaction, there is a prima facie case for collective provision. If CGS markets could be shown to produce public goods that enhance national interest, which cannot be produced in any other (more efficient) way, then this would be a strong, pro-CGS argument.
But we argued that: (a) the benefits identified by Treasury which are used to justify the retention of the CGS market can be enjoyed without CGS issuance; and (b) more importantly, these benefits cannot be conceived as public goods, and rather, at best, appear to accrue to narrow special interests.
While the maintenance of financial system stability meets the definition of a public good and is the legitimate responsibility of government, the roles identified by IMF (in the paper – IMF (2002) The Changing Structure of the Major Government Securities Markets: Implications for Private Financial Markets and Key Policy Issues, Chapter 4), the Treasury and SFE Discussion Papers among others for the CGS market are not justifiable on public good grounds.
We also argued that:
They appear to be special pleading by an industry sector for public assistance in the form of risk-free CGS for investors as well as opportunities for trading profits, commissions, management fees, and consulting service and research fees.
Furthermore, and ironically, their arguments are inconsistent with rhetoric forthcoming from the same financial sector interests in general about the urgency for less government intervention, more privatisation (for example, Telstra), more welfare cutbacks, and the deregulation of markets in general, including various utilities and labour markets.
We justified this conclusion by closely examining futures markets, the superannuation markets and related issues. It should be understood that CGS are in fact government annuities. We asked the question:
Do the proponents of CGS 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 CGS facilitate portfolio diversification. Why would Australians want to provide government annuities to private profit-seeking investors? … 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.
So the continued issuance of debt despite the Government running surpluses was really a form of “corporate welfare” – to provide safe investment vehicles to private investment banks.
We argued that all the logic used by the Government in the Treasury Discussion Paper applies only to a fixed exchange rate regime. With flexible exchange rate, where monetary policy is freed from supporting the exchange rate, there is no reason for CGS issuance.
We argued that in this context the real policy issue was how well the Government was performing relative to the essential goal of full employment. We concluded the macroeconomic strategy had failed badly. This is how we put it. So you will see that 7 years ago we were predicting today’s mess (in actual fact I have writing going back to 1996 predicting the crisis):
Despite the government rhetoric that the “strategy has contributed to Australia’s sound macroeconomic framework and continuing strong economic performance”, the recent economic growth has been in spite of the contractionary fiscal policy. Growth since 1996 has largely reflected increased private sector leveraging as private deficits have risen. Further, the recent ability of the Australian economy to partially withstand the world slowdown is due to the election-motivated reversal of the Government’s fiscal strategy, which generated the first deficit in 2001-02 since 1996-97.
A return to the pursuit of surpluses will ultimately be self-defeating. For all practical purposes any fiscal strategy ultimately results in a fiscal deficit as unsustainable private deficits unwind. But these deficits will be associated with a much weaker economy than would have been the case if appropriate levels of net government spending had have been maintained.
The basic lessons of macroeconomics that arise from all of this are:
- Firms produce to meet expected spending. All output will be sold if spending equals the sum of all income. If an agent spends less than its income, output will go unsold unless another agent goes into debt and buys that output.
- If there is a generalised net desire to save – output will go unsold and the stock build-up will lead to declining production and employment. The reverberations of the lost incomes generate a downward spiral in output.
- In this situation, the economic outcome depends entirely on the policy response by government. If demand for private production falls but people still desire to work then there is no valid reason not to switch them to public goods production until private demand recovers.
- Unemployment results when the policy response inhibits this switch. Surprisingly, most commentators and public officials fail to realise that the unemployed, supported by welfare measures, are already ‘in the public sector’. A sensible policy response would utilise this capacity to both attempt to produce socially beneficial outputs, and reduce socially detrimental reactions to unemployment.
- In this regard, it is desirable to let market forces determine the level of government deficit spending. A fixed-wage Job Guarantee policy can attenuate any tendency towards financial instability and provide the ‘switch’ between private and public sector employment over the business cycle as well as provide an ‘anchor’ effect to the price level.
- It is ironic that during a time of heightened appreciation of market forces, the option to let market forces determine the size of the fiscal deficit has not been open to discussion. But it is not surprising, if the presumed fixed exchange rate assumptions and restrictions take precedence.
[BACK TO THE CAFE]
“So it is all a scam?”
“Yes” [monosyllabic answer]
And after all that the conversation continued. It first went back to Ted Theodore (the Ted Theodore nut is hard to stop once the narrative is flowing).
The conversation then went onto Flash programming with a digression into Cognitive Linguistics and a talk that one of the assemblage gave in Maryland (USA) last week about the linguistic patterns that are found in particular Early Modern plays [We have a computational linguistics nut among us].
Finally the discussion moved onto the current water temperature (cold = 16 Celsius) and how booties and gloves have been pulled out of the cupboard to make surfing bearable in the cold.
Cups of tea were being drunk and everybody seemed to be happy.
…. then someone [the same would-be economist] started to say something about the role the IMF was playing in … at which point
[BACK TO THE CAFE – BILL GETS UP, PUTS HIS HAT ON AND SAYS]
“Lovely morning all, see you next Saturday … ”
“But the IMF are vandals … ”
“Yes” [monosyllabic answer]
Life in Newcastle (NSW) on a Saturday morning in Winter. I swear I am going to retrain as a bread maker should I become unemployed.
My loving whatever (partner? we are not a business; wife, legally; lover, definitely etc) after the cafe went to the local craft fair which is held monthly. It is mostly a social event as far as I can see. I didn’t go this time because I went to the office instead to tinker with a server or two. Anyway, the report is that during this visit to the fair, people met people and introductions were made. Some local economics consultant was introduced – there is an industry of consultants in this region like there is in all regions … mostly tacking onto property developers and mostly prepared to write things they shouldn’t if science was the guide … but that is another story.
The conversation apparently went something like this:
Person making the introduction: Lxxxxx is married to an economist – Bill Mitchell.
Local economics consultant: Yes, I know of him. He is a communist.
End of script.
So last week I was told in Upper New York State at a large workshop I presented at, that talking about modern monetary theory as a basis for full employment is considered by (so-called) experts to be an ideological distraction to the main economic development debate in LDCs.
And now we find out that to other economists, talking about modern monetary theory represents the development of a new Communist Manifesto!
It is interesting how far right the world debate has gone and how ignorant many so called experts who make a living as professional economists are.
I would add … being called a communist gave Saturday afternoon a nice warm sunny glow despite the cold water!