Modern monetary theory in an open economy

A number of readers write to me asking me about the applicability of modern monetary theory (MMT) to less developed economies and open economies generally. The issues are not entirely the same for both cases but there is a strong commonality. The aim of this blog is to advance the understanding of how MMT deals with open economy issues. They remain mysterious to most people and grossly misrepresented by those who claim to understand.

I have recently completed an assignment for the Asian Development Bank about Pakistan. Consider this statement about Pakistan, which appeared in The Economist, October 23, 2008 edition under the title The Last Resort:

… Pakistan faces economic meltdown … The economy is close to freefall. Inflation is running at about 30%. The rupee has devalued by about 25% in just three months. The fiscal deficit is a whopping 10% of GDP. Foreign-exchange reserves cover just six weeks of imports. A $500m Eurobond matures next February, but the market has already decided it is junk. The country needs at least $3 billion in short order, and a further $10 billion over the next two years to plug a balance-of-payments gap. Without it, default abroad might well coincide with political anarchy at home.

A week or so later The Economist (October 29, 2008) under the title Pakistan’s wounded sovereignty continued to emphasise that:

Without foreign help, Pakistan won’t be able to afford its imports, repay its debts, or quell the insurgents encamped within its borders. Thanks to protracted power cuts, it cannot even keep the lights on in its towns and villages. It is not, in other words, a state in full command of itself … Pakistan is running out of hard currency … The deterioration in Pakistan’s economy has escalated quickly in recent months and the Pakistan Government has now formally requested $US15 billion in financial assistance from the International Monetary Fund … The Government clearly needs time to deal with the burgeoning balance of payments deficits and the unsustainable loss of foreign exchange reserves. The aims of the Government in seeking IMF funds is to, as it sees it, stabilise the macroeconomic imbalances, generate a buffer of foreign exchange reserves and stimulate investment expectations.

So you get the picture – living beyond their means -> currency attack -> depletion of foreign reserves … etc.

The overriding view among economists is that in these situations there is a gross imbalance between aggregate supply and aggregate demand which have generates inflation and rising imports. These problems, in turn, lead to a rapid depletion of foreign exchange reserves and sharp markdowns in the currency.

MMT will never lead us to conclude that a nation is “living beyond its means” and, should therefore, scale back government spending and private consumption, when there is substantial unused capacity and underutilised resources (particularly labour). In those circumstances, the nation could not possibly be living beyond its means. As a consequence the mainstream policy recommendations are always likely to worsen the situation rather than improve it.

Further, MMT does not advocate net public spending per se. There are some growth strategies which will be unsustainable. Overall, a model of long-run growth and sustainable development requires a careful balancing of internal and external forces.

Clearly, when an economy that experiences a depletion of foreign exchange reserves has to take some hard decisions in relation to its external sector, especially if it is reliant on imported fuel and food products. In these situations, a burgeoning CAD will threaten the dwindling international currency reserves.

In some cases, given the particular composition of exports and imports, currency depreciation is unlikely to resolve the CAD without additional measures.

The depreciation, in turn, raises the relative costs of imports, and imparts an inflationary bias to the economy. Moreover, depreciation leads to expectations of further depreciation and fuels the run out of the currency. There may be no interest rate that is high enough to counter expectations of losses due to depreciation and possible default.

In the short run there is probably no alternative but to urgently restore reserves of foreign currency either through renegotiation of foreign debt obligations, international donor assistance or default.

The orthodox interpretation of a burgeoning CAD indicates that the nation “living beyond its means” – with excessive domestic demand that boosts imports; the excessive demand also fuels inflation that restricts exports. The presumption is that this CAD must be “financed” by flows of foreign reserves, which for the most part must be attracted by high returns and a stable political, economic, and social environment.

So the worsening trade account indicates that local consumption becomes dependent on the whims of foreign lenders. Further, if the nation has a large budget deficit, then its government is said to be increasingly dependent on the foreign purchases of its debt to supplement domestic savers’ purchases of government debt.

If the nation cannot attract these needed reserves, it must slow its growth to reduce imports; lower prices and wages could also encourage exports. The obvious portent of the default on foreign debt obligations then is used to argue in favour of restricting government spending. Thus, both monetary and fiscal policy ought to be tightened to encourage such capital flows even as this reduces the need for them.

Further, the orthodox interpretation of fiscal deficits is that they drive interest rates up (through competition for limited loanable funds) while generating inflation (excess demand). High interest rates, in turn, are argued to squeeze out productive investment, making the nation less competitive internationally. This hinders improvement in the trade balance, and competitiveness is further hurt by inflation.

Thus there is a fairly direct link claimed to follow from budget deficits to trade deficits – the so-called “twin deficits” hypothesis. This is why the mainstream believe it is imperative to reduce budget deficits. According to the logic, that would allow interest rates to fall, inflation to be reduced, lowering pressure on the external balance and exchange rates.

The supposed link between net spending and interest rates is predicated on the notion that sovereign governments have to “finance” any deficit spending, in the same way that a household has to fund spending above income (ignoring asset depletion options).

Such a link is purely voluntary and that it is not required for a sovereign government that wishes to maintain a sustainable fiscal strategy based on deficits.

The “twin deficits” hypothesis is further based on crucial assumptions about the private domestic balance (relationship between saving and investment) which have rarely held in practice.

Finally, the “crowding-out” and “twin deficits” arguments are critically based on a supposed relation between government “borrowing” and interest rates where deficits push interest rates higher. As I argue below, MMT shows you that this belief is wholly without foundation and reflects a fundamental misconstruction of the way interest rates are determined.

Inflation biases

Many nations face high inflation and persistent and significant unemployment of its domestic resources. In these instances, what is required is a development strategy that mobilises the domestic resources to improve incomes and reduce supply bottlenecks. Given substantial levels of redundant resources, it should have been obvious that the inflationary bias could not be a simple matter of excessive demand.

Thus, in appraising the inflationary impact it is incorrect to presume that fiscal policy has been excessively expansionary. Budget deficits can result from insufficient aggregate demand – with the budget deficit endogenously expanding via revenue losses and spending increases when gaps in spending appear.

Using budget deficits as evidence of expansionary policy is therefore erroneous, unless the deficits have pushed the economy beyond full capacity use of its resources. For this reason, fiscal restraint may not be the medicine that is required in a situation in which a country is actually living below its means – as indicated by idle or underutilised resources.

But won’t growth via deficit spending worsen this situation? Robust growth will tend to generate a CAD if there is a relatively low income elasticity of demand for the country’s exports.

From the mainstream perspective the consequences of encountering balance-of-payments problems before short-term capacity utilisation is reached are straightforward. Demand has to be curtailed, unemployment increased, and capital accumulation has to be reduced. This leads, in the long run, to a relative deterioration of the country’s export potential compared with that of its main competitors. This situation tends to lead to a vicious circle with further balance-of-payments problems.

MMT recognises this problem, but doesn’t recommend the mainstream solution.

For a sovereign nation – that is a “modern money regime” – that includes flexible exchange rates, the government has more domestic policy space than the maintream consider.

The government can make use of this space to pursue economic growth and rising living standards even if this means expansion of the CAD and depreciation of the currency.

While there is no such thing as a balance of payments growth constraint in a flexible exchange economy in the same way as exists in a fixed exchange rate world, the external balance still has implications for foreign reserve holdings via the level of external debt held by the public and private sector.

But it is also advisable that a nation facing continual CADs foster conditions that will reduce its dependence on imports. However, the mainstream solution to a CAD will actually make this more difficult.

Indeed, IMF lending and the accompanying conditions that are typically imposed on the debtor nation almost always reduce the capacity of the government to engineer a solution to the problems of inflation and falling foreign currency reserves without increasing the unemployed buffer stock. A policy strategy based largely on fiscal austerity will create unacceptable levels of socio-economic hardship.

Targets to reduce budget deficits may help lower inflation, but only because the “fiscal drag” acts as a deflationary mechanism that forces the economy to operate under conditions of excess capacity and unemployment.

This type of deflationary strategy does not build productive capacity and the related supporting infrastructure and offers no “growth solution”. And fiscal restraint may not be successful in lowering budget deficits for the simple reason that tax revenue can fall as the taxable base shrinks because economic activity is curtailed.

Moreover, the lessons of how the international crises of the 1990s and early 2000s were dealt with should not be forgotten: fiscal discipline has not helped developing countries to deal with financial crises, unemployment, or poverty even if they have reduced inflation pressures.

There are also inherent conflicts between maintaining a strong currency and promoting exports – a conflict that can only be temporarily resolved by reducing domestic wages, often through fiscal and monetary austerity measures that keep unemployment high. The best way to stabilise the exchange rate is to build sustainable growth through high employment with stable prices and appropriate productivity improvements.

A low wage, export-led growth strategy sacrifices domestic policy independence to the exchange rate – a policy stance that at best favours a small segment of the population.

Then we encounter the “printing money” conception of MMT. Whenever the government runs a deficit (and according to the mainstream it should not on average do this over the cycle), it should turn to “private markets” for its borrowing. It will then need to offer sufficiently attractive interest rates on its debt; this will allow the government’s borrowing costs to rise to market rates.

Further, the argument that nations should adopt inflation targets and prioritise monetary policy in this regard is not supportable. Not only does the preponderance of empirical evidence suggest that moderate inflation does not hinder economic growth, but also recent experience in those countries that have adopted inflation targets or even less restrictive Taylor-type rules for policy formation casts doubt on such approaches.

It is somewhat ironic that the wealthy, developed countries are abandoning such policy while the less developed economies under the bullying of the IMF are being encouraged (forced as part of loan arrangements) to adopt it. Many observers now believe the world is heading into a highly deflationary environment.

Further, in my recent book with Joan Muysken (Full Employment Abandoned) we show that there is very little evidence for the claim that inflation targeting has succeeded where it was tried.

Even if it is believed that inflation targeting following some kind of a Taylor rule – increasing interest rates when prices are rising too fast – can fight some kinds of inflation, there is little reason to believe that monetary policy can successfully fight inflation pressures that arise outside a nation.

If inflation comes largely from commodities and other imports (or even from domestic output that competes in international markets hence that experiences the same price pressures), it is hard to see how higher domestic interest rates can reduce inflation pressures. In some cases, tighter monetary policy might appreciate the exchange rate, so that “pass through” inflation could be reduced. But this will not quell an international asset price bubble.

The final point that has been highlighted in the current crisis is that monetary policy is not nearly so powerful a stabilisation tool as it was once thought to be. The real economy is not excessively sensitive to interest rates movements.

During recessions, monetary policy has little proven effects in activating an economy. In bad times lower interest rates do not induce consumer expenditure. And likewise, lower interest rates do not induce more investment (by making borrowing cheaper) as during these periods there tends to be excess capacity and output is not sold.

Empirical evidence suggests that the interest elasticity of investment is at best low, non-linear, and asymmetric. While an increase in interest rates might moderately reduce investment during economic booms (when the economy is at or above capacity), the reverse is not true. In general, it is the outlook for profitability, rather than the price of credit, that influences investment.

For this reason, direct credit control is a more effective instrument of monetary policy than the interest rate. If monetary policy includes direct credit controls it may be reasonable to assume that there will be some effect on aggregate demand.

In addition, using high interest rates to target inflation generates other undesirable consequences. Interest is a cost of doing business, and tends to be included in price. For this reason, raising interest rates will reduce inflation only if the effects on interest-sensitive spending (lowering aggregate demand) are greater than the effects on costs and prices.

When inflation comes from the supply side, higher interest rates will probably add to supply-side induced inflation by raising costs. Also, interest rate increases will increase the debt service burden. There is one commonly cited condition for sustainability: the interest rate should not exceed the growth rate of income and GNP. If it does, debt will tend to grow faster than ability to service the debt at a constant burden (ratio of debt service to income).

While this constraint is often inappropriately applied to sovereign government (a sovereign government can always service its debt in its own currency), it should be applied to the private sector (and non-sovereign government such as states and provinces or local governments).

So we now know that monetary policy cannot successfully fight inflation that comes from the supply side. We also know that monetary policy as indicated by low interest rates cannot help to pull an economy out of recession. It is certain that fiscal policy will play a much larger role from this point forward, and that alternative methods of fighting inflation pressures will be developed.

Finally, some believe that increases in interest rates will have a significant impact in preventing the depreciation of a currency. This way, imported inflation will not worsen due to the currency depreciation. History is full of many examples of countries trying to use higher interest rates to protect the currency, only to find that the policy was impotent.

Raising interest rates by hundreds of basis points cannot compensate investors for losses due to large currency depreciations. Indeed, the higher rates can stoke a run out of the currency as currency speculators bet that the monetary policy will fail to stabilise the currency.

Monetisation and sterilisation

Before I tackle the external sector issues further a few conceptual matters need to be clarified.

I keep reading that MMT advocates the central bank monetising the deficit. This notion is inapplicable to a flexible exchange rate, fiat currency monetary system.

It stems from the fallacious idea that the national government faces a budget constraint in the same way that a household operates. This errant analogy is advanced by the popular government budget constraint framework (GBC) that now occupies a chapter in any standard macroeconomics textbook. The GBC is used by orthodox economists 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 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. A student who takes a typical macroeconomics course at any university will go away with the totally erroneous view that taxation and debt-issuance takes money from the private sector, which is then respent by the government. Nothing could be further from the truth.

What is missing is the recognition that a household, the user of the currency, 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) as we have seen in the previous section. Clearly the government is always solvent in terms of its own currency of issue.

Standard macro textbooks struggle to explain this to students. Usually, there is some text on so-called money creation but no specific discussion of the accounting that underpins spending, taxation and debt-issuance. Blanchard’s 1997 macroeconomics book is representative and tells us that government (p.429):

… 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.

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. 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. All government spending in a flexible exchange rate system, is operationalised by the government crediting bank accounts (directly or indirectly by issuing cheques). This process adds to bank reserves. Alternatively, taxation payments to government result in bank accounts being debited and reserves being reduced. So a budget deficit is a net reserve add or a net credit to commercial bank accounts.

If we understand the banking operations that accompany these transactions further, we will learn that those who receive the net payments from the government are in possession of bank liabilities which are matched by the banks’ reserve positions which are central bank liabilities. Some of the deposits are held in the form of cash but this is a nuance.

Note that irrespective of what else the government (via the treasury or the central bank) does in relations to the operational management of the cash system (bond sales) and/or aggregate demand management (taxation changes), government spending is the same process. So the alleged three sources of finance noted in the GBC literature are misnomers and mislead you into thinking that the process of government spending differs depending on how it is “financed”. The problem with this conception, of-course, it that government spending does not need to be financed in a fiat monetary system.

But this operational understanding of the way governments spend has no application for the subject of “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.

Why is the central bank so constrained?

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 in typical times. 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.

But what about a zero interest rate situation? Good question. Then the central bank does not have to conduct any debt-issuance when there is a budget deficit. They just have to leave sufficient reserves in the system to bid the overnight rate down.

The more important point though is the GBC is just an accounting statement (identity) of all the transactions that have gone on between the government and the non-government sector.

As a result of the institutional arrangements (debt is issued to match net spending etc), we know that whenever government spending increases you will find an equal increase in the sum of taxation revenue + high powered money (bank reserves and cash) + public debt. You might like to read this blog to get some further insights on this – Will we really pay higher taxes?.

As an ex post accounting statement this sum carries no further weight. It certainly doesn’t substantiate the view that the increased taxation, money base, or debt provided any funds to the government which enabled it to spend.

There is a related concept that also introduces confusion and leads to erroneous statements. This is the term – central bank sterilisation. It stems from the gold standard, fixed exchange rate system and occurs when the central bank attempts to insulate (sterilise) the domestic economy from its foreign exchange market interventions designed to maintain the fixed (agreed) parity.

So the central bank in an economy with a trade deficit (that is, facing downward pressure on its exchange rate) will buy its own currency (reducing supply) and sell foreign currency (increasing demand). Of-course, the contraction in the money supply has domestic impacts (higher interest rates and less aggregate demand).

To overcome the domestic interest rate impacts, the central bank can simultaneously conduct open market operations and buy public debt back thus increasing the money supply to offset the contraction occcuring via the forex market.

That is how sterilisation occurs in the fixed exchange rate system. It assumes many things about the capacity of the central bank to control the money supply. But it is also totally inapplicable in a flexible exchange rate regime where the central bank does not have to compromise its exogenous capacity to set domestic interest rates.

This also helps us clear up a lot of nonsense about who funds whom. We continually read that nations with current account deficits (CAD) are living beyond their means and are being bailed out by foreign savings. This claim is particularly potent in the current US-China context.

In MMT, this sort of claim would never make any sense. As I have indicated often a CAD can only occur if the foreign sector desires to accumulate financial (or other) assets denominated in the currency of issue of the country with the CAD. This desire leads the foreign country (whichever it is) to deprive their own citizens of the use of their own resources (goods and services) and net ship them to the country that has the CAD, which, in turn, enjoys a net benefit (imports greater than exports). A CAD means that real benefits (imports) exceed real costs (exports) for the nation in question.

This is why I always say that the CAD signifies the willingness of the citizens to “finance” the local currency saving desires of the foreign sector. MMT thus turns the mainstream logic (foreigners finance our CAD) on its head in recognition of the true nature of exports and imports.

Subsequently, a CAD will persist (expand and contract) as long as the foreign sector desires to accumulate local currency-denominated assets. When they lose that desire, the CAD gets squeezed down to zero. This might be painful to a nation that has grown accustomed to enjoying the excess of imports over exports. It might also happen relatively quickly. But at least we should understand why it is happening.

Sterilisation enters the scene here as well. It is often erroneously thought that financial inflows (corresponding to the CAD) via the capital account of the Balance of Payments boost commercial bank reserves. Mainstream economists who operate within the defunct money multiplier paradigm think this might be inflationary because it will stimulate bank credit creation.

The flawed logic is – increased bank reserves -> increased capacity to lend -> increased credit -> excess aggregate demand -> inflation.

You might like to read this blog – Money multiplier and other myths – to understand why that is totally at odds with the way the credit creation system operates.

The claim is that the central bank can “sterilise” this impact by selling government debt via open market operations. However, if there is excess capacity in the economy, the central bank might refrain from sterilising and allow aggregate demand to expand.

But think about what a CAD actually means. I always argue that it is essential to understand the relationship between the government and non-government sector first. A common retort is that this blurs the private domestic and foreign sectors. My comeback is that the transactions within the non-government sector are largely distributional, which doesn’t make them unimportant, but which means you don’t learn anything new about the process net financial asset creation.

In the case of CAD, what mostly happens is that local currency bank deposits held say by Australians are transferred into local currency bank deposits held by foreigners. If the Australian and the foreigner use the same bank, then the reserves will not even move banks – a tranfer occurs between the Australian’s account in say Sydney, to the foreigner’s account with the same bank in say Frankfurt.

If the transactions span different banks, the central bank just debits and credits, respectively, the reserve accounts of the two banks and the reserves move.

What happens next depends on the approach the commercial banks take to the reserve positions. Just as we saw in the discussion about “monetisation”, excess reserves put downwards pressure on overnight interest rates and may compromise the rate targetted by the central bank.

The only way the central bank can maintain control over its target rate and curtain the interbank competition over reserve positions is to offer an interest-bearing financial asset to the banking system (government debt instrument) and thus drain the excess reserves. So sterilisation in this case merely reflects the desire of the central bank to maintain a particular target interest rate and is not discretionary. The alternative is to offer a return on excess returns equivalent to the target rate.

Back to trade etc …

MMT shows that fiscal deficits result in net injections of banking system reserves that due to common (voluntarily imposed) arrangements are drained through sales of government debt either in the new issue market (by Treasury) or through open market sales (by the central bank).

If the (stupid) voluntary arrangements which force governments to match $-for-$ their net spending with bond sales were abandoned then the central bank would start accumulating treasury assets (maybe via formal bond sales but more sensibly via some numbers in an accounting ledger to keep record of the transactions). International financial markets would immediately (and erroneously) believe that this accumulation of represents “monetisation of the deficit”, and that this contributes to inflationary pressures, although the empirical evidence is scant.

If there is inflationary pressure, it would result from the government spending, not from the bond sales that drain excess reserves.

Problems are greatly compounded if the nation has issued foreign-currency denominated debt. If this debt is issued by private firms (or households), then they must earn foreign currency (or borrow it) to service debt. To meet these needs they can export, attract FDI, and/or engage in short-term borrowing. If none of these is sufficient, default becomes necessary.

There is always a risk of default by private entities, and this is a “market-based” resolution of the problem.

If however the government has issued (or taken over) foreign currency denominated debt, default becomes more difficult because there is no well delineated international method. Often, the government is forced to go to international lenders to obtain foreign reserves; the result can be a vicious cycle of indebtedness and borrowing.

Since international lenders request austerity, domestic policy becomes hostage. For this reason, it is almost always poor strategy for government to become indebted in foreign currency. By contrast, a sovereign government can never face insolvency in its own currency.

Budget deficits in a sovereign, floating, currency never entail solvency risk. Sovereign government can always “afford” whatever is for sale in terms of its own currency. It is never subject to “market discipline”. A sovereign government spends by crediting bank accounts, and it can never “run out” of such credits.

When it credits the bank account of any recipient of its spending (whether this is for purchases of goods and services or for social welfare spending), the central bank simultaneously credits the bank’s reserve account. If this leads to excess reserves, these are then exchanged for treasury debt. While the IMF and other mainstream financial analysts criticise sales of treasury debt to the central bank (or corresponding accounting entries), it actually makes no difference whether treasury sells the debt to private banks. In effect the sales directly to the central bank simply bypass the bank “middlemen”.

If you think there is a difference between treasury debt being sold the central bank or to the commercial banks then you do not understand reserve accounting which is at the heart of MMT.

The reality is that the end result will be the same: the distribution of treasury debt holdings between the central bank and the private sector will depend on portfolio preferences of the private sector. These preferences are reflected in upward or downward pressure on the overnight interest rate. To hit its target, the central bank must accommodate private sector preferences by either taking the debt into its portfolio, or by selling the debt to reduce bank reserves.

The only complication is that the treasury can issue debt of different maturities. Very short-term treasury debt is equivalent to bank reserves that earn interest. Long term treasury debt is not a perfect substitute because capital gains and losses can result from changes to interest rates.

Hence if there is a lot of uncertainty about the future course of interest rates, trying to sell long-term treasury debt to private markets can affect interest rates and the term structure. For example, selling long-term debt that is not desired by the private sector will lead to low prices and high interest rates for that debt. In this case, it is not really the case that budget deficits are affecting interest rates, but rather the decision to sell debt with a maturity that is not desired by markets. The solution would be to limit treasury debt to short-term maturity.

A country that operates on a gold standard, or a currency board, or a fixed exchange rate is constrained in its ability to use the monetary system in the public interest, because it must accumulate reserves of the asset(s) to which it has pegged its exchange rate.

This leads to significant constraints on both monetary and fiscal policy because they must be geared to ensure a trade surplus that will allow accumulation of the reserve asset. This is because such reserves are required to maintain a credible policy of pegging the exchange rate. On a fixed exchange rate if a country faces a current account deficit, it will need to depress domestic demand, wages and prices in an effort to reduce imports and increase exports. In a sense, the nation loses policy independence to pursue a domestic agenda.

Floating the exchange rate effectively frees policy to pursue other, domestic, goals like maintenance of full employment.

An important point to be made regarding treasury operations by a sovereign government is that the interest rate paid on treasury securities is not subject to normal “market forces”. The sovereign government only sells securities in order to drain excess reserves to hit its interest rate target. It could always choose to simply leave excess reserves in the banking system, in which case the overnight rate would fall toward zero.

When the overnight rate is zero, the Treasury can always offer to sell securities that pay a few basis points above zero and will find willing buyers because such securities offer a better return than the alternative (zero).

This drives home the point that a sovereign government with a floating currency can issue securities at any rate it desires-normally a few basis points above the overnight interest rate target it has set.

There may well be economic or political reasons for keeping the overnight rate above zero (which means the interest rate paid on securities will also be above zero). But it is simply false reasoning that leads to the belief that the size of a sovereign government deficit affects the interest rate paid on securities.

You might wonder why so many governments around the world fail to understand this – I don’t wonder that – it is simply because they are politically pressured by neo-liberal ideology into a state of ignorance.

When the central bank desires to target a non-zero interest rate, budget deficits will thus lead to growing debt and increased interest payments. However, the interest rate is a policy variable for any sovereign nation which can increase its deficits and its outstanding debt while simultaneously lowering its interest payments by lowering interest rates.

Let us contrast the discussion above with the situation of a non-sovereign nation that tries to peg its exchange rate. A non-sovereign government faces an entirely different situation. In the case of a “dollarised” nation, the government must obtain dollars before it can spend them. Hence, it uses taxes and issues IOUs to obtain dollars in anticipation of spending.

Unlike the case of a sovereign nation, this government must have “money in the bank” (dollars) before it can spend. Further, its IOUs are necessarily denominated in dollars, which it must incur to service its debt. In contrast to the sovereign nation, the non-sovereign government promises to deliver third party IOUs (that is, dollars) to service its own debt (while the US and other sovereign nations promise only to deliver their own IOUs).

Furthermore, the interest rate on the non-sovereign, dollarized government’s liabilities is not independently set. Since it is borrowing in a foreign currency, the rate it pays is determined by two factors. First there is the base rate on the foreign currency. Second, is the market’s assessment of the non-sovereign government’s credit worthiness. A large number of factors may go into determining this assessment. The important point, however, is that the non-sovereign government, as user (not issuer) of a currency cannot exogenously set the interest rate. Rather, market forces determine the interest rate at which it borrows.

For a real world example of the benefits of adopting a floating, sovereign, currency we can look to Argentina.

The crisis was engendered by faulty (neo-liberal policy) in the 1990s. Between 1991 and 2002, Argentina essentially adopted a currency board by pegging the Argentine peso to the US dollar for reasons that beg belief. This faulty policy decision ultimately led to a social and economic crisis that could not be resolved while it maintained the currency board.

However, as soon as Argentina abandoned the currency board, it met the first conditions for gaining policy independence: its exchange rate was no longer tied to the dollar’s performance; its fiscal policy was no longer held hostage to the quantity of dollars the government could accumulate; and its domestic interest rate came under control of its central bank.

At the time of the 2001 crisis, the government realised it had to adopt a domestically-oriented growth strategy. One of the first policy initiatives taken by newly elected President Kirchner was a massive job creation program that guaranteed employment for poor heads of households. Within four months, the Plan Jefes y Jefas de Hogar (Head of Households Plan) had created jobs for 2 million participants which was around 13 per cent of the labour force. This not only helped to quell social unrest by providing income to Argentina’s poorest families, but it also put the economy on the road to recovery.

Conservative estimates of the multiplier effect of the increased spending by Jefes workers are that it added a boost of more than 2.5 per cent of GDP. In addition, the program provided needed services and new public infrastructure that encouraged additional private sector spending. Without the flexibility provided by a sovereign, floating, currency, the government would not have been able to promise such a job guarantee.

Argentina demonstrated something that the World’s financial masters didn’t want anyone to know about. That a country with huge foreign debt obligations can default successfully and enjoy renewed fortune based on domestic employment growth strategies and more inclusive welfare policies without an IMF austerity program being needed. And then as growth resumes, renewed FDI floods in.

One commentator wrote a few years ago that that the Argentinian Government appears to have perpetuated the perfect crime. The Government offered the world financial markets a ‘take-it-or-leave-it’ settlment which was favourable to the local economy. At the time, the rhetoric claimed that countries that treat foreign creditors so badly would surely stagnate and suffer a FDI boycott.

This is the standard neo-liberal line that is used to coerce debtor nations into compliance with the needs of ‘first-world’ capital largely defined through the aegis of the IMF. But the Argentinean case shows this paradigm to be toothless because the Government defied the major players including the IMF and the Argentine economy went on to boom despite it.

It is clear that many foreign firms are expanding in Argentina in addition to strong investment from Argentine interests. The country’s biggest real estate developer explained (in 2005) the quandary facing the neo-liberals as such: “there has never been a better time to invest in Argentina … [as for foreign banks, after shunning Argentina for a while] … now the banks are coming to us … It’s been tough. We will have restrictions … But in terms of access to capital, what defines access? Greed. When opportunities look profitable, access to capital will be easy.”

This is a lesson all countries should learn. International capitalism, ultimately does not really take ‘political’ decisions – it just pursues return.

The clear lesson is that sovereign governments are not necessarily at the hostage of global financial markets. They can steer a strong recovery path based on domestically-orientated policies – such as the introduction of a Job Guarantee – which directly benefit the population by insulating the most disadvantaged workers from the devastation that recession brings.

Argentina’s defiance has lessons for Australia. Many critics of the Job Guarantee argue that the international financial markets would wreak havoc on the Australian economy if it was introduced here. This is clearly just a neo-liberal myth. My view is that the international investment community would soon realise that rather than being a threat to their activities, the introduction of a Job Guarantee would provide them with an even better investment climate in which to chase return. It is time that we abandoned the neo-liberal myths and instead realise that in capitalism ‘greed comes before prejudice’.

Should CADs be prevented?

The other implication of the mainstream view is that policy should be focused on eliminating CADs. This would be an unwise strategy.

First, it must be remembered that for an economy as a whole, imports represent a real benefit while exports are a real cost. Net imports means that a nation gets to enjoy a higher living standard by consuming more goods and services than it produces for foreign consumption.

Further, even if a growing trade deficit is accompanied by currency depreciation, the real terms of trade are moving in favour of the trade deficit nation (its net imports are growing so that it is exporting relatively fewer goods relative to its imports).

Second, CADs reflect underlying economic trends, which may be desirable (and therefore not necessarily bad) for a country at a particular point in time. For example, in a nation building phase, countries with insufficient capital equipment must typically run large trade deficits to ensure they gain access to best-practice technology which underpins the development of productive capacity.

A current account deficit reflects the fact that a country is building up liabilities to the rest of the world that are reflected in flows in the financial account. While it is commonly believed that these must eventually be paid back, this is obviously false.

As the global economy grows, there is no reason to believe that the rest of the world’s desire to diversify portfolios will not mean continued accumulation of claims on any particular country. As long as a nation continues to develop and offers a sufficiently stable economic and political environment so that the rest of the world expects it to continue to service its debts, its assets will remain in demand.

However, if a country’s spending pattern yields no long-term productive gains, then its ability to service debt might come into question.

Therefore, the key is whether the private sector and external account deficits are associated with productive investments that increase ability to service the associated debt. Roughly speaking, this means that growth of GNP and national income exceeds the interest rate (and other debt service costs) that the country has to pay on its foreign-held liabilities. Here we need to distinguish between private sector debts and government debts.

The national government can always service its debts so long as these are denominated in domestic currency. In the case of national government debt it makes no significant difference for solvency whether the debt is held domestically or by foreign holders because it is serviced in the same manner in either case – by crediting bank accounts.

In the case of private sector debt, this must be serviced out of income, asset sales, or by further borrowing. This is why long-term servicing is enhanced by productive investments and by keeping the interest rate below the overall growth rate. These are rough but useful guides.

Note, however, that private sector debts are always subject to default risk – and should they be used to fund unwise investments, or if the interest rate is too high, private bankruptcies are the “market solution”.

Only if the domestic government intervenes to take on the private sector debts does this then become a government problem. Again, however, so long as the debts are in domestic currency (and even if they are not, government can impose this condition before it takes over private debts), government can always service all domestic currency debt.


A national government should always aim to to design a budget with a view to the economic effects desired, rather than with a deficit target in mind. In other words, tax and spending reform should be formulated to accomplish economic, social, and political objectives rather than to hit a deficit target.

Further, governments will not be able to achieve their budget deficit target even if it were to cut drastically spending on social services (education, health, etc.) and development expenditures. This is because such draconian cuts would be likely to throw the economy into a deep recession that would reduce tax revenues.

If a country has a chronic and crippling shortage of foreign reserves, then the government should negotiate with the multilateral agencies to develop a program that would allow the country to service its external debt, and gradually reduce its trade deficit until it reaches a more manageable level.

Unilateral default on external obligations following Argentina’s experience is always an option. While it is frequently argued that default on debt is dangerous because future access to credit will be denied, that does not appear to be the case, historically. Indeed, entering formal bankruptcy proceedings often eases access to credit markets for households and firms for the obvious reason that relief from debt burdens makes it easier to service new debt.

While budget deficits are likely to raise living standards which will increase the CAD it should always be noted that all open economies are susceptible to balance of payments fluctuations. These fluctuations were terminal during the gold standard for deficit countries because they meant the government had to permanently keep the domestic economy is a depressed state to keep the imports down. For a flexible exchange rate economy, the exchange rate does the adjustment.

Is there evidence that budget deficits create catastrophic exchange rate depreciations in flexible exchange rate countries? None at all. There is no clear relationship in the research literature that has been established. If you are worried that rising net spending will push up imports then this worry would apply to any spending that underpins growth including private investment spending. The latter in fact will probably be more “import intensive” because most LDCs import capital.

Indeed, well targetted government spending can create domestic activity which replaces imports. For example, Job Guarantee workers could start making things that the nation would normally import including processed food products.

Moreover, a fully employed economy with skill development structure embedded in the employment guarantee are likely to attract FDI in search of productive labour. So while the current account might move into deficit as the economy grows (which is good because it means the nation is giving less real resources away in return for real imports from abroad) the capital account would move into surplus. The overall net effect is not clear and a surplus is as likely as a deficit.

Even if ultimately the higher growth is consistent with a lower exchange rate this is not something that we should worry about. Lower currency parities stimulate local employment (via the terms of trade effect) and tend to damage the middle and higher classes more than the poorer groups because luxury imported goods (ski holidays, BMW cars) become more expensive.

These exchange rate movements will tend to be once off adjustments anyway to the higher growth path and need not be a source of on-going inflationary pressure.

Finally, where imported food dependence exists – then the role of the international agencies should be to buy the local currency to ensure the exchange rate does not price the poor out of food. This is a simple solution which is preferable to to forcing these nations to run austerity campaigns just to keep their exchange rate higher. The IMF would do well to reform its charter and adopt this role instead of the destructive role it currently plays around the world.

This Post Has 15 Comments

  1. Hi Bill,

    Wonderfully written blog as always. The best description on the state of international Economics and how the world can improve.

    In India, because of low rainfall this year, food prices increased a lot. The press, the central bank and the markets started talking of rate hikes especially after the RBA increased short term rates. The RBI (Indian Central Bank) Governor seems to realize that increasing the short term rates will not cause the food prices to go up and non-monetary steps are needed to tackle the situation. He has already gone on record saying that central banks should not be playing the inflation targeting game earlier. Unfortunately he will still fall into the mainstream economics trap! For example, he has been asking the government to cut down the fiscal deficit!

    Another thing that has been happening is that the Indian central bank seems to have allowed a bit of dollar depreciation (Rupee appreciation) to reduce import costs. Fortunately it is good for now but unfortunately they will not learn from this and make mistakes later.

    I am not so good at analyzing history but I remember foreign debt troubled India a lot about 15-20 years back and if I remember correctly, the IMF was involved a lot in all this. And interest rates in India were abnormally high.

    On the fiscal side, the Indian FM told the Parliament and the media that he had intentionally kept the fiscal decifit high and didn’t go with the ‘disinvestment’ where the government offers more stake for investors in the public sector companies. However he will still go back to targets such as 3% deficits in the future unfortunately. But it is great that India started the National Rural Employment Guarantee Scheme. Hopefully it picks up.

    Obsession of the mainstream economists with IS/LM and the Taylor Rule, government deficit and debt and finally the Mundell-Fleming model has really taken away so much out of the production sector where people work and produce excellent goods and brilliant ideas!

  2. Bill,

    Thanks for this fantastic post! You have cleared up more questions for me in this one post than in my previous 2 years of muddling through various works from other economic schools of thought!

    I will have to investigate the situation in Argentina more fully. This seems like a good example for Latvia as an example. What of Spain however? It would seem that their hands are tied as a result of being a “state” as it were in the EU and are not in a modern money regime. Are they to remain trapped in a deflation? I imagine so given the EU and IMF’s belief in neo-classical ideas…


  3. Bill,

    Superb analysis; two questions:

    “Sterilisation enters the scene here as well. When there are net financial inflows (corresponding to the CAD) – so via the capital account of the Balance of Payments – commercial bank reserves are boosted.”

    Maybe I’ve misunderstood this point, but I’m not sure why commercial bank reserves increase in this case. (In considering this, I’m assuming a capital account surplus offsets a current account deficit as a definitional identity.)

    It seems to me it works this way only if the government purchases goods and services directly from the foreign sector, in which case commercial bank reserves increase as a reflection of offsetting capital inflows. The capital account surplus then corresponds to an increase in both reserves and commercial bank deposit liabilities. That works, but it’s an exceptional example by construction.

    Otherwise, assuming the same level of current account deficit as in the first case, the private sector purchases goods and services from the foreign sector, in which case commercial bank reserves remained unchanged. The capital account surplus corresponds to a change in ownership of commercial bank deposit liabilities and reserves, but does not increase bank reserves. (It may or may not correspond to an increase in domestic bank credit). Accordingly, a change in commercial bank reserves comparable to the first case must result from the government purchasing goods and services from the private sector instead of the foreign sector.

    Therefore, foreign capital inflows don’t necessarily link directly with the causality of domestic reserve creation or net saving directly with the government. The foreign sector can arrange its position with either/both the government or/and domestic private sectors in a variety of ways in order to achieve its desired net saving position. While the non government sector can only net save with the government sector, there are different ways in which the private and foreign subcomponents can net save or not with each other and the government, and still end up in the same consolidated net save position with the government.

    I have a strong feeling that this is obvious to you, and that you were making a different point that I’ve overlooked or misinterpreted. Or I’m wrong in my analysis.

    Second question:

    With reference to your penultimate section on CAD, how does one think about the global constraint in the sense that the sum of CA positions globally is zero? I’m sure the reasoning is found in the section implicitly, but it would round out the discussion by referring to that perspective explicitly. One might be tempted otherwise to think that global balance is achieved by those who understand MMT running CAD positions, and those who don’t running CAS positions, which doesn’t seem to be a very satisfying resolution.

  4. Dear JKH

    Thanks for the elaboration on reserves. It was just an oversight on my behalf – typing too quickly and not enough time to proof read (I often re-read the posts early next morning – like now) and edit glitches. The correct statement is that commercial bank reserves are unaltered unless it is a transaction between the government and the non-government. I will edit that to correct the slip. The subsequent analysis is consistent with your point.

    On the second question – I did not that not all countries can have CADs which was a reference to the global accounting constraint you note. I have also said before that for some countries they can have strong sustainable economic growth with budget deficits without indebting their domestic private sector – if they enjoy strong net exports (such as, Norway). But that this is not a general rule that a country can rely on. Those statements again recognise the global CAD accounting constraint that the sum = zero.

    I just ran out of typing time last evening and had typed more than I had planned. But the point is a good one.

    best wishes

    best wishes

  5. An export of goods a production firm, say, worth ¥7m in China to the US increases the assets of commercial banks in China by $1m and the liabilities by ¥7m. (Rounding off) The production firm’s assets grow by ¥7m as deposits. The Chinese Central Bank PBC will get the $1m and pay the commercial banks in ¥7m reserves. However this is thought to be inflationary by economists and the PBC will sterilize it. They don’t need to but will necessarily have to do so to defend overnight rates. Because of reserve requirements of around 15%, the central bank bonds issued will be just ¥7mx85% = ¥5.95m

    In the case of capital inflow, of say $1m however, there is an increase in reserves in the following way. The commercial banks’ assets increase by $1m and liabilities will increase by ¥7m. The PBC may/will aquire the $1m from the commercial banks and pay ¥7m in reserves. Again it has to sterlize ¥5.95m in order to defend overnight rates.

    Am I missing something here ?

  6. Bill,

    I think you have a non-trivial typo: “That a country with huge foreign debt obligations can default successfully and enjoy renewed fortune based on domestic employment growth strategies and more inclusive welfare policies with an IMF austerity program being needed.” I believe you meant “…WITHOUT an IMF austerity plan being needed.”

  7. A great post
    Some quick questions.
    You say:

    A country that operates on … a fixed exchange rate is constrained in its ability to use the monetary system in the public interest, because it must accumulate reserves of the asset(s) to which it has pegged its exchange rate.
    This leads to significant constraints on both monetary and fiscal policy because they must be geared to ensure a trade surplus that will allow accumulation of the reserve asset. This is because such reserves are required to maintain a credible policy of pegging the exchange rate. On a fixed exchange rate if a country faces a current account deficit, it will need to depress domestic demand, wages and prices in an effort to reduce imports and increase exports. In a sense, the nation loses policy independence to pursue a domestic agenda.
    Floating the exchange rate effectively frees policy to pursue other, domestic, goals like maintenance of full employment.

    So this means that under the Bretton Woods system (1945-1971) all countries except the US had constraints on their fiscal and monetary policies (particularly when they had current account deficits)?

    But why is it that the Bretton Woods era delivered superior economic growth, greater increases in per capita GDP and in living standards than the neoliberal era?

    If floating the exchange rate actually increased the power of governments to spend, then why has the neoliberal era been such a dismal failure, especially in the Third World?

    China has a fixed exchange rate, but its growth has been spectacular.

  8. Ramanan,

    IMO, you’re missing nothing.

    Managing a (relatively) fixed FX rate requires defensive measures as necessary against dollar inflows through both current and capital accounts.

  9. That is a good point Ramanan, but I would add that the short-term riskless bonds used to sterilize the the RMB issuance are the equivalent of cash in terms of bank capital, as Bill pointed out (“In a broad sense, a federal (fiat currency issuing) government’s debt is money”), so that this type of sterilization is incapable of limiting the growth of aggregate ratios such as M1/GDP.

    The exporter who makes a deposit of 7M still has an additional 7M to spend on the existing pool of domestic capital and goods, and the exporter’s bank has the same balance sheet lending constraints whether or not it keeps the cash or purchases government debt with 85% of the cash. Short term central bank debt is equivalent to cash in most regulatory frameworks.

    The only difference, if any, is that the overnight rates do not fall due to the excess reserve position. However even this situation is a bit complicated. Only in an idealized equilibrium scenario will a cash injection of X, given a capital ratio requirements of Y, lead to a requirement that the central bank purchase (1-Y)*X in the overnight market in order to keep the rate unchanged. Reserve requirements are a function of balance sheet size in addition to the nominal size of reserves. And these factors are not independent: I.e. increased profits of export firms will tend to raise asset prices and the demand for loans. Therefore, taken as a whole, the central bank may be required to sterilize much less than it would based on the static ratio, and it may even need an expansionary position to maintain rates if balance sheets overall are expanding quickly. These banking booms and busts are particularly acute in China, and the end result is that CB rate targeting is ineffectual at countering the effects of either asset price inflation or consumer price inflation. The only way to achieve those goals is to prevent the 7M surplus from occurring in the first place — i.e. fundamentally you are adding money to the economy without a corresponding increase in finished goods that the money can purchase. Once that happens on an large, ongoing scale, no amount of rate targeting or swapping cash for bonds will prevent asset or consumer price inflation from occurring, even if rates remain fixed.

  10. The China-US relationship has always been fascinating. It takes two to tango and if the US were serious about changing the peg – it wouldn’t take much in the way of trade tariffs to create the equivalent of a float. However, that would be too “political” and “anti free trade” to be a realistic option. Despite the occasional noise made by US politicians – they really need the peg.

    It looks as if China has reached the point where sterilization is less effective re: inflation targeting while still maintaining the peg. This may be a factor for China reducing its purchasing of US paper.

    I also wonder to what extent China can increase near term domestic consumption using the production assets built over the past 25 years. Do the Chinese really need cheap toys, electronics, shopping malls and a supply chain optimized for export? Infrastructure spending has been going on for a while – but at some point there needs to be output (or imports) for domestic consumption – which is currently running at about 35% of GDP.

  11. Hi you have some interesting points out there but overall I’m not buying it. Your theory gets in the game “what was first, Hen or egg” and declares “Hen” and suggests that Hen should eat the eggs in order to survive:)
    It’s quite arrogant to say that some new theory is going to solve all problems. Important thing here t orealize is that there is no such a thing as government, it is only an infrastructure that is utilized by the people in power and their sponsors to serve their short term interests. Coming from post-communist country run by “cleptocrats” I can see where your experiment would lead – there is also some FDI in North Korea and yes, capitalists are greedy but they eventually learn when they will burn themselves a few times. Try to follow your conclusions to ad absurdum and you see how absurd they really are.

  12. Dear Jakub

    Welcome to my blog and thanks for your comment.

    First, it is not a new theory.

    Second, it doesn’t claim to solve all problems. Please read carefully so as you understand which problems modern monetary theory does address.

    Third, the theoretical observations developed in this blog is generally not about outlining a new world order (although sometimes I explicitly suggests new reforms). The thing is that the work is about the system you are currently living in whether you like it or not. It describes the operations today not in the future. So we are already in the oblivion that you are afraid of.

    Finally, which conclusions exactly are absurd? Comments that use terms like “arrogant”, “absurd”, “I was in a communist country and I know how bad it was” etc without actually addressing any of the content of my work do not get us very far – do they?

    best wishes

  13. Love the blog, I have some questions about this post:

    “But it is also advisable that a nation facing continual CADs foster conditions that will reduce its dependence on imports”

    Could you please elaborate on why it is advisable?

    “Is there evidence that budget deficits create catastrophic exchange rate depreciations in flexible exchange rate countries? None at all. There is no clear relationship in the research literature that has been established. If you are worried that rising net spending will push up imports then this worry would apply to any spending that underpins growth including private investment spending”

    Unless the source of private investment spending is FDI, no?

    “If inflation comes largely from commodities and other imports (or even from domestic output that competes in international markets hence that experiences the same price pressures), it is hard to see how higher domestic interest rates can reduce inflation pressures.”

    If the interest rates are low at home, people will exchange that currency for ones that yield higher returns. As a result the currency will depreciate and make imports more expensive. Am I missing something?

  14. one last question:

    Would it be advisable for a country running a CAD to just not exchange the foreign currency for domestic to avoid the decline of terms of trade and the inflation that comes with it?

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