I read an article in the Financial Times earlier this week (September 23, 2023) -…
This is the second blog in the series that I am writing to help explain why we should not fear deficits. In this blog we clear up some of the myths that surround the so-called “financing” of budget deficits. In particular, I address the myth that deficits are inflationary and/or increase the borrowing requirements of government. The important conclusion is that the Federal government is not financially constrained and can spend as much as it chooses up to the limit of what is offered for sale. There is not inevitability that this spending will be inflationary and it does not necessarily require any increase in government debt.
The first thing to recall from Part 1 is that spending by private citizens is constrained by the sources of available funds, including income from all sources, asset sales and borrowings from external parties. Federal government spending, however, is largely facilitated by the government issuing cheques drawn on the central bank. The arrangements the government has with its central bank to account for this are largely irrelevant. When the recipients of the cheques (sellers of goods and services to the government) deposit the cheques in their bank, the cheques clear through the central banks clearing balances (reserves), and credit entries appear in accounts throughout the commercial banking system. In other words, government spends simply by crediting a private sector bank account at the central bank. Operationally, this process is independent of any prior revenue, including taxing and borrowing. Nor does the account crediting in any way reduce or otherwise diminish any government asset or government’s ability to further spend.
Alternatively, when taxation is paid by private sector cheques (or bank transfers) that are drawn on private accounts in the member banks, the central bank debits a private sector bank account. No real resources are transferred to government. Nor is government’s ability to spend augmented by the debiting of private bank accounts.
In general, mainstream economics errs by blurring the differences between private household budgets and the government budget. Statements such as this one from reputed economist Robert Barro that “we can think of the government’s saving and dissaving just as we thought of households’ saving and dissaving” are plain wrong.
Mainstream economics uses the government budget constraint framework (GBC) to analyse three alleged forms of public finance: (1) Raising taxes; (2) Selling interest-bearing government debt to the private sector (bonds); and (3) Issuing non-interest bearing high powered money (money creation). Various scenarios are constructed to show that either deficits are inflationary if financed by high-powered money (debt monetisation), or squeeze private sector spending if financed by debt issue. While in reality the GBC is just an ex post accounting identity, orthodox economics claims it to be an ex ante financial constraint on government spending.
The GBC framework leads students to believe that unless the government wants to print money and cause inflation it has to raise taxes or sell bonds to get money in order to spend. People have the erroneous understanding that taxation and bond sales provide money for the government which they use to spend. So if the government increases its deficit (spending more than taxing) then it must be increasing its debt holdings or “printing money”, both of which are deemed undesirable.
However the reality is far from this erroneous conception of the way the Federal government operates its budget. First, a household, uses the currency, and therefore must finance its spending beforehand, ex ante, whereas government, the issuer of the currency, necessarily must spend first (credit private bank accounts) before it can subsequently debit private accounts, should it so desire. The government is the source of the funds the private sector requires to pay its taxes and to net save (including the need to maintain transaction balances). Clearly the government is always solvent in terms of its own currency of issue.
Mainstream economics also misrepresents what it calls “money creation”. In the popular macroeconomics text, Olivier Blanchard (1997) says that government
can also do something that neither you nor I can do. It can, in effect, finance the deficit by creating money. The reason for using the phrase “in effect”, is that … governments do not create money; the central bank does. But with the central bank’s cooperation, the government can in effect finance itself by money creation. It can issue bonds and ask the central bank to buy them. The central bank then pays the government with money it creates, and the government in turn uses that money to finance the deficit. This process is called debt monetization.
This is what mainstream economists call “printing money”. However, it is an erroneous conception in terms of the monetary system. To monetise means to convert to money. Gold used to be monetised when the government issued new gold certificates to purchase gold. Monetising does occur when the central bank buys foreign currency. Purchasing foreign currency converts, or monetises, the foreign currency to the currency of issue. The central bank then offers federal government securities for sale, to offer the new dollars just added to the banking system a place to earn interest. Interest-free payments, long-term plans as a method of payment for the consumer goods* are relieving techniques at online stores. This process is referred to as sterilisation. In a broad sense, a federal (fiat currency issuing) government’s debt is money, and deficit spending is the process of monetising whatever the government purchases.
It is actually rather obvious but all government spending involves money creation. But this is not the meaning of the concept of debt monetisation as it frequently enters discussions of monetary policy in economic text books and the broader public debate. Following Blanchard’s conception, 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 government debt or newly issued government debt. In Part 3 I will show that 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. 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 government debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to any support rate that it might have in place for excess reserves. We will consider this step-by-step in Part 3.
In summary, we conclude from the above analysis that governments spend (introduce net financial assets into the economy) by crediting bank accounts in addition to issuing cheques or tendering cash. Moreover, this spending is not revenue constrained. A currency-issuing government has no financial constraints on its spending, which is not the same thing as acknowledging self imposed (political) constraints.
Once we realise that government spending is not revenue-constrained then we have to analyse the functions of taxation in a different light. 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.
The orthodox conception is that taxation provides revenue to the government which it requires in order to spend. In fact, the reverse is the truth. Government spending provides revenue to the non-government sector which then allows them to extinguish their taxation liabilities. So the funds necessary to pay the tax liabilities are provided to the non-government sector by government spending. It follows that the imposition of the taxation liability creates a demand for the government currency in the non-government sector which allows the government to pursue its economic and social policy program.
This insight allows us to see another dimension of taxation which is lost in mainstream analysis. Given that the non-government sector requires fiat currency to pay its taxation liabilities, in the first instance, the imposition of taxes (without a concomitant injection of spending) by design creates unemployment (people seeking paid work) in the non-government sector. The unemployed or idle non-government resources can then be utilised through demand injections via government spending which amounts to a transfer of real goods and services from the non-government to the government sector. In turn, this transfer facilitates the government’s socio-economics program. While real resources are transferred from the non-government sector in the form of goods and services that are purchased by government, the motivation to supply these resources is sourced back to the need to acquire fiat currency to extinguish the tax liabilities.
Further, while real resources are transferred, the taxation provides no additional financial capacity to the government of issue. Conceptualising the relationship between the government and non-government sectors in this way makes it clear that it is government spending that 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 (which we define as 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 through the offer of labour 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.
So the purpose of State Money is to facilitate the movement of real goods and services from the non-government (largely private) sector to the government (public) domain. Government achieves this transfer 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 the non-government sector’s 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 (saving) decisions in force at any particular time.
For a time, what may appear to be inadequate levels of net government spending can continue without rising unemployment. In these situations, as is evidenced in countries like the US and 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 “run out of borrowing capacity” as incomes limit debt service. This tends to restructure their balance sheets to make them less precarious and as a consequence the aggregate demand from debt expansion 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. It is difficult to imagine that an increasing deficit will be inflationary in a recessed economy because there are so many underutilised resources, both capital and labour.
Indeed, as I continually point out, the first thing that the Federal government should do is offer all the labour that no-one else wants a job and pay them a minimum wage with all the additional statutory entitlements. By definition, the unemployed have no “market price” because there is no demand for their labour. Offering to buy a service for which there is no price is not an inflationary act.
In Part 3, we consider the argument that deficits automatically drive up interest rates because the government borrowing squeezes available funds in the money markets. As you will guess … this is another neo-liberal myth which is designed to render government’s inactive.