I read an article in the Financial Times earlier this week (September 23, 2023) -…
One question that continually comes up when I do interviews is this: If governments are not financially constrained in their spending why do they issue debt? Usually, the question is expressed in an incredulous tone, meaning that the person asking the question considers this to be the gotcha moment, when they pierce the impeccable logic of Modern Monetary Theory (MMT) and show it for what it is – a sham. One problem is that there is a tendency to confuse motivation with function and many people sympathetic to MMT reduce it to simple statements that belie the reality. One such statement, relevant to this topic, is that government’s issue debt to allow the central bank to maintain a specific short-term interest rate target. Central banks have traditionally used government debt as an interest-rate maintenance tool. But that is a function of the debt rather than being the motivation for issuing the debt in the first place. So we explore those differences today as a means of clarifying the questions and confusions around this issue. This is Part 1 of a two-part series, which I will finish tomorrow.
Pre-World War 2 currency systems
To understand the situation now, one has to understand what went before.
During the C18th, so-called commodity currency systems, where a currency might be valued for its intrinsic value. became problematic because there was a shortage of silver and this system steadily gave way to a system where paper money issued by a central bank was backed by gold.
So the idea was that a currency’s value can be expressed in terms of a specified unit of gold.
To make this work there had to be convertibility which meant that someone who possessed a paper note would be able to convert it for the relevant amount of gold.
So the – Gold standard – was deployed where the value of currencies around the world was regulated in terms of a certain amount of gold. When the gold standard was in vogue (C19th into the C20th) it was the major way that countries adjusted their money supply.
Britain adopted the gold standard in 1844 and it became the common system regulating domestic economies and trade between them up until World War I. In this period, the leading economies of the world ran a pure gold standard and expressed their exchange rates accordingly.
The monetary authority 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).
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.
Nations experiencing an inflow of gold could then expand the money supply (issue more notes) because they had more gold to back the currency. This expansion was in strict proportion to the set value of the currency in terms of grains of gold.
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.
Central banks in nations experiencing a loss of gold reserves were forced to withdraw paper currency which was deflationary – rising unemployment and falling output and prices. The latter improved the competitiveness of their economy which also helped 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.
The proponents of the gold standard focus on the way it prevents the government from issuing paper currency as a means of stimulating their economies.
Under the gold standard, the government could not expand base money if the economy was in trade deficit. It was considered that the gold standard acted as a means to control the money supply and generate price levels in different trading countries which were consistent with trade balance. 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). Variations in the gold production levels also influenced the price levels of countries.
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.
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.
The onset of World War I interrupted the operation of the gold standard and currencies were valued by whatever the specific government wanted to set it at.
The ensuing 25 odd years saw significant instability with attempts to go back to the standard in some countries proving extremely damaging in terms of gold losses and rising unemployment.
The UK abandoned the gold standard in 1931 as it was facing massive losses of gold.
It had tried to maintain the value of the Pound in terms the pre-WW1 parity with gold but the war severely weakened its economy and so the pound was massively over-valued in this period and trade competitiveness undermined as a consequence.
Debt issuance under the Bretton Woods system
In an effort to achieve currency stability at the end of World War 2. the Bretton Woods System was introduced in 1946 and created the fixed exchange rates system.
This was the creation of the so-called – Gold exchange standard – to replace the flawed gold standard.
The IMF was also created to act as the multilateral lender to nations to ensure they could maintain the agreed exchange rate parities.
Convertibility to gold was abandoned and replaced by convertibility into the USD, reflecting the dominance of the US in world trade (and the fact that they won the War!).
This new system was built on the agreement that the US government would convert a USD into gold at $USD35 per ounce of gold. This provided the nominal anchor for the exchange rate system.
Governments could now sell gold to the US Treasury at the price of $USD35 per ounce.
The fixed exchange rate system however rendered fiscal policy relatively restricted because monetary policy had to target the exchange parity.
If the exchange rate was under attack (perhaps because of a balance of payments deficit) which would manifest as an excess supply of the currency in the foreign exchange markets, then the central bank had to intervene and buy up the local currency with its reserves of foreign currency (principally $USDs).
This meant that the domestic economy would contract (as the money supply fell) and unemployment would rise.
Further, the stock of $USD reserves held by any particular bank was finite and so countries with weak trading positions were always subject to a recessionary bias in order to defend the agreed exchange parities.
The IMF functioned to provide currency reserves if needed, but increasingly (in the 1960s) adopted conditionality (austerity) as part of the deal which was counterproductive.
The system became politically difficult to maintain because of the social instability arising from unemployment and austerity.
If fiscal policy was used too aggressively to reduce unemployment, it would invoke a monetary contraction to defend the exchange rate as imports rose in response to the rising national income levels engendered by the fiscal expansion.
Ultimately, the primacy of monetary policy ruled because countries were bound by the Bretton Woods agreement to maintain the exchange rate parities. They could revalue or devalue (once off realignments) but this was frowned upon and not common.
Whichever system we want to talk off – pure gold standard or USD-convertible system backed by gold – the constraints on government were obvious.
The gold standard as applied domestically meant that existing gold reserves controlled the domestic money supply. Given gold was in finite supply (and no new discoveries had been made for years), it was considered to provide a stable monetary system. But when the supply of gold changed (a new field discovered) then this would create inflation.
So gold reserves 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.
As a consequence, bank reserves were limited and if the public wanted to hold more currency then the reserves would contract. This state defined the money supply threshold.
The concept of (and the term) monetisation comes from this period. When the government acquired new gold (say by purchasing some from a gold mining firm) they could create new money.
The process was that the government would order some gold and sign a cheque for the delivery. This cheque was deposited by the miner in their bank.
The bank then would exchange this cheque with the central bank in return for added reserves.
The central bank then accounted for this by reducing the government account at the bank.
But in terms of today’s post, this history is important.
A major implication of this system was that the national government could only increase the money supply by acquiring more gold.
Any other expenditure that the government desired to make would have to be ‘financed’ by taxation and if they wanted to spend more than their tax revenue, they had to issue debt.
Debt-issuance was required to ensure the monetary authority didn’t lose control of the exchange rate.
Governments were not able to just credit a commercial bank account under this system via their central banks in order to increase their 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.
Ultimately, Bretton Woods collapsed in 1971.
It was under pressure in the 1960s with a series of “competitive devaluations” by the UK and other countries who were facing chronically high unemployment due to persistent trading problems.
Ultimately, the system collapsed because Nixon’s prosecution of the Vietnam war forced him to suspend USD convertibility to allow him to net spend more.
He announced that the US was abandoning the convertibility system on August 15, 1971, which paved the way for the introduction of fiat currencies.
This was the final break in the links between a commodity that had intrinsic value and the nominal currencies.
From this point in, governments used fiat currency as the basis of the monetary system.
And on an historical note, this is the ‘modern’ part of MMT – it applies to monetary systems post Bretton Woods.
Now what difference did this make to the debt-issuance motivation?
Fiat currency systems
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.
You need to recognise this major shift in history before you can understand why the economic policy ideas that prevailed in the previous monetary systems (based on convertibility) are no longer applicable.
You cannot assume that the logic that applied in the fixed exchange rate-convertibility days translates over into the fiat currency era.
Mainstream macroeconomic reasoning is really the sort of reasoning that prevailed in the days prior to fiat currency.
While there were debates about how to conduct macroeconomic policy in those days, there were some obvious key constraints that I have outlined above.
This is irrespective of whether you want to call yourself a Keynesian or a Monetarist.
The shift in history also renders most of the textbook economics outdated and wrong, in terms of how they depict the operations of the fiat monetary system.
The collapse of the Bretton Woods system dramatically altered the opportunities available to currency-issuing governments.
First, under a fiat monetary system, ‘state money’ no longer any intrinsic value.
It is non-convertible which means that you can take, say, a $AUD coin to the government and in return you will get a $AUD coin back. There is no responsibility to do more than this.
So for this otherwise “worthless” currency to be acceptable in exchange (buying and selling things) some motivation has to be introduced. That motivation emerges because the sovereign government has the capacity to require its use to relinquish private tax obligations to the state.
Under the gold standard and its derivatives, money was always welcome as a means of exchange because it was convertible to gold which had a known and fixed value by agreement. This is a fundamental change.
Second, given the relationship between the commodity backing (gold) and the ability to spend is abandoned and that the Government is the monopoly issuer of the fiat currency in use (defined by the tax obligation) then the spending by this government is revenue independent.
It can spend however much it likes subject to there being real goods and services available for sale. This is a dramatic change.
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.
This is not to say there are no restrictions on government spending.
The constraints become the available real goods and services available for sale, including all the unemployed labour.
So we traverse from thinking about financial constraints and the need to ‘fund’ spending to avoid compromising central bank responsibilities to maintain a particular exchange rate parity, to a focus on real resource constraints defined in terms of available productive resources and available final goods and services.
This is a dramatic shift in thinking.
It doesn’t mean that the spending, taxing and borrowing decisions of the national government do not impact on interest rates, economic growth, private investment, and price level movements.
Third, what it means is that the gold standard rationale for issuing public debt is no longer applicable.
In a fiat currency system, the government does not need to ‘finance’ its net spending (deficits), in which case the issuing of debt by the treasury has to serve other purposes.
Why then do governments continue to issue public debt when there is no financial need for them do to so?
We have established an important understanding today – that the usual justifications for currency-issuing governments issuing debt are not sustainable.
In Part 2, we will consider some of the other justifications.
We will see that none are sustainable.
That is enough for today!
(c) Copyright 2020 William Mitchell. All Rights Reserved.