Regular readers will know that I have spent quite a lot of time reading the…
Functional finance and modern monetary theory
Today I am continuing my recent theme of considering the flaws in the standard progressive attack on neo-liberalism. I will write sometime about manufacturing but it is Sunday and it has been a beautiful day here and I don’t feel like setting off the flamethrowers out there that clearly think manufacturing is important. It might be, but the standard arguments are based on a vertically integrated conception of the sector that we haven’t had for years anyway. But later. Today, I consider the “public debt is good” approach that progressive use to counter the manic “public debt is always bad” arguments proferred by the mainstream of my profession.
The vehicle I use to explore this issue is yesterday’s economic commentary by the Sydney Morning Herald’s Ross Gittins – No infrastructure unless you borrow (published October 31, 2009).
Get this straight: if you think we should be spending a lot more on economic infrastructure, you can’t be chicken-hearted about government debt. Similarly, if you think debt-free is the only acceptable way for governments to be, resign yourself to living in an economy characterised by bottlenecks at ports, inadequate rail and road systems, rising congestion on urban roads, inadequate public transport and the threat of urban water shortages.
As a literary device he often opens articles or paragraphs with statements such as “get this straight” or “get this” and similar. It is a way of trying to capture authority and to portray to the reader that he knows something about the topic he is writing about. I just think … poor fool reader – hoodwinked again.
Anyway, his opening juxtaposition is a standard ploy by “self-styled” progressives who think they are being reasonable in the face of the conservative morality and denial that public investment is useful.
But of-course, the argument is, in itself conservative and fails to reflect an understand of the way the modern monetary system operates and the opportunities that fiat monetary system offers to governments.
It’s not good enough for big business to be demanding hugely increased spending on infrastructure while looking the other way as its Coalition mates do all in their power to put the frighteners on the punters over government deficits and debt. That was the simplistic, short-sighted and self-serving line of Peter Costello that did so much to help create our infrastructure backlog. The more success his successors have in using it against the easily frightened Rudd Government, the more inadequate its infrastructure efforts will be.
The simple point is that, to a large extent, spending on capital works has to be financed by borrowing. That’s the way the private sector always does it and governments have to do it, too.
Well I agree with the first point – the sheer hypocrisy of the conservative side of politics and the games big business play to extract as much corporate welfare for themselves and deny as much social welfare to the disadvantaged. It is not as if big business does much that is worth anything anyway (in my view). I value public goods well above the private goods that are available.
I also agree with the criticisms of the past conservative government (Costello was Treasurer – see later on him) and the weak-kneed current government. I haven’t written anything about the federal government’s handling of the current refugee crisis in the north west – but suffice to say is is a bit more tricky (read sneaky) than the brazen way Howard and his government handled the matter – but none the less shameful. Maybe a separate blog on this but it would just be a stream of personal consciousness rather than any professional level understanding (as is my usual blogs) and I tend to avoid this sort of writing – that is what Saturday morning cups of tea are about!
But the final paragraph is straight ignorance – and just takes us back down the deficit-dove road back to nowhere – that is, nowhere progressive.
First, spending on capital works could easily be realised without a cent of debt being issued. Not a cent is required to allow a sovereign government to spend whatever it likes subject to goods and services being available for sale. This is not the same thing as saying the government can always build infrastructure without concern for other dimensions in the aggregate economy.
For example, if the economy was at full capacity and the government tried to undertake a major nation building exercise then it might hit inflationary problems – it would have to compete at market prices for resources and bid them away from their existing uses.
In those circumstances, the government may – if it thought it was politically reasonable to build the infrastructure – quell demand for those resources elsewhere – that is, create some unemployment. How? By increasing taxes. It might also issue debt – more about which later. But neither of these actions (tax rate rises or debt-issuance) would be about raising funds for the spending. They would not even be remotely about that.
As we will see in a moment – these policy actions are about reducing the amount of spending capacity in the private sector.
Second, the analogy that if it is okay for the the corporate sector to borrow to invest and earn profits, then it must be okay for government to follow the same strategy, even if the profits are in the form of social returns, is flawed at the most elemental level. It is often used by progressives in a way that they think skewers the conservatives. Then the debate, they think, has to shift to the returns on the “investment” rather than the act of “financing” it via debt.
The problem is that the corporate sector has to finance its spending (whether it be consumption or investment) from a variety of sources, one of which is debt. It is the user of the currency and so it is always revenue-constrained.
Conversely, the sovereign government is the monopoly issuer of the currency and is never revenue-constrained. So it never has to “obey” the constraints that the private sector always has to obey.
The household/corporate/government analogy is a non-sequiter. It is a basic tactic used by mainstream economists to come up with all the nonsense that appears in the text books which ultimately is used to argue against deficits and to justify moralistic fiscal rules.
In the influential textbook by Mankiw “The Principles of Economics” (First edition) we read on page 767 in the chapter “Five Debates over Macroeconomic Policy” that:
The most direct effect of the government debt is to place a burden on future generations of taxpayers. When these debts and accumulated interst come due, future taxpayers will face a difficult choice. They can pay higher taxes, enjoy less government spending, or both, in order to make resources available to pay off the debt and accumulated interest. Or they can delay the day of reckoning and put the government into even deeper debt by borrowing once again to pay off the old debt and interest. In essence, when the government runs a budget deficit, it allows current taxpayers to pass the bill for some of their government spending on to future taxpayers. Inheriting such a large debt cannot help but lower the living standard of future generations.
In addition to this direct effect, budget deficits also have various macroeconomic effects. Because budget deficits represent negative public saving, they lower national saving (the sum of private and public saving). Reduced national saving causes real interest rates to rise and investment to fall. Reduced investment leads over time to a smaller stock of capital. A lower capital stock reduces labor productivity, real wages, and the economy’s production of goods and services. Thus, when the government increases its debt, future generations are born into an economty with lower incomes as well as higher taxes.
Now this nonsensical view of the way the monetary system operates is based on the same fundamental building blocks as Gittin’s view expressed above. The only difference between the two (and between deficit-doves and the more extreme mainstreamers) is that the former think there is some return on the public investment which transfers to future generations and justifies the higher tax burden they have to bear as a consequence of the public debt accumulation.
None of these arguments are remotely correct in a fiat monetary system.
… if you want adequate infrastructure you have to be prepared to live with a fair bit of debt. And if you want to build all the additional economic – and social – infrastructure needed to cope with a 60 per cent increase in the population over the next 40 years, you have to be prepared to live with a huge whack of debt. As every economist understands, there’s nothing wrong with borrowing a high proportion of the cost of infrastructure, provided that infrastructure efficiently fulfils a genuine need. That is, provided it earns an adequate “social” rate of return (not necessarily an actual, money-in-the-hand rate of return).
The point is that capital works – from a new police station to a new port – deliver a flow of services stretching over 20, 30 or 40 years. Borrowing to cover, say, half the cost of the work is a way of sharing its cost between the present and future generations who will benefit from its services.
There’s a price to be paid for this sharing – and for gaining the services of the facility before we’ve saved sufficient money to be able to buy it for cash – of course, and that’s the interest bill. Nothing wrong with that …
When the Opposition carries on about all this debt and interest burden we’re leaving for our children, it forgets to mention the benefits that go with the debt. It’s not clear our children would be better off if we left them a debt-free government, but also a world with inadequate infrastructure.
So you see that the difference between the two views turns on whether the public investment delivers future returns that offset (to some extent) the costs that are imposed on future generations.
However, there is no understanding that a sovereign government does not have to reach a point where it says – today, we have to pay the debt back … therefore we have to cut spending on other things or increase taxes. It might have to make those decisions but as we will see not because it issued the debt in the first place.
But Gittins digs himself further in a hole by trying to be cute:
… Maybe in an ideal world you and I would hold off buying things until we’d saved enough to pay cash, thereby avoiding all debt and interest payments.
Trouble is, many of us don’t have sufficient self-control to keep saving until we’ve got enough. We’d end up spending more than we should on cheap frivolities and not enough on durable items that could make a big difference to the amenity of our lives.
Thus borrowing turns out to be a form of ”commitment device” to overcome our self-control problem. It’s not just a way of getting to use something before you can afford it, it’s also a way of leaving yourself no choice but to save.
When you borrow to buy something, you don’t avoid having to save. You just do your saving in retrospect (as you make your monthly repayments), rather than in prospect. The interest you pay is the cost of doing your saving in reverse because you lack the self-control to save before you buy.
It’s possible that what’s true for individuals has some parallel at government level. Where governments eschew debt, they probably save less than they otherwise would, end up with less adequate infrastructure and spend more on less-beneficial bits and pieces on the way through.
It is not possible that there is any parallel between the individal person (clearly revenue-constrained) and the national government. This is the worst of the worst when it comes to trying to explain the options facing a sovereign government in a fiat monetary system.
The two choice (and constraint) sets are not alike in any way, except that neither can buy what is not available for sale. After that point, there is no similarity or analogy that can be exploited.
Of-course, the evolution in the 1960s of the literature on the so-called government budget constraint (GBC), was part of a deliberate strategy to argue that the microeconomic constraint facing the individual applied to a national government as well. So therefore while the individual had to pay the piper when he/she spent so to did the government. This provided the conservatives who hated public activity and were advocating small government, with the ammunition it needed.
It used this concept (GBC) relentlessly to justify the sort of statements that Mankiw (above) drums into his poor impressionable students, who should sue him for being deceived during their university education.
And Gittins uses his influential column to perpetuate the same myths even though he is trying to appear reasonable and distance himself from the manic deficit terrorists. The problem is that he is one of them.
This all reminded me of Abba Lerner and his notions of functional finance. Here is a useful Bio of Lerner.
Lerner’s objective was to advance economic policy debate beyond what he called “sound finance” (which is the precursor of modern mainstream (neo-liberal) thinking). So he juxtaposed the his “economics of control” policy thinking with the dominant laissez-faire approach that prevailed during the Great Depression.
Chapter 1 of Lerner’s 1951 book The Economics of Employment, was really a rewritten version of the 1941 article The Economic Steering Wheel where he elaborated his version of Keynesian thinking. He began the book as such (1951: 3-5):
Our economic system is frequently put to shame in being displayed before an imaginary visitor from a strange planet. It is time to reverse the procedure. Imagine yourself instead in a Buck Rogers interplanetary adventure, looking at a highway in a City of Tomorrow. The highway is wide and straight, and its edges are turned up so that it is almost impossible for a car to run off the road. What appears to be a runaway car is speeding along the road and veering off to one side. As it approaches the rising edge of the highway, its front wheels are turned so that it gets back onto the road and goes off at an angle, making for the other side, where the wheels are turned again. This happens many times, the car zigzagging but keeping on the highway until it is out of sight. You are wondering how long it will take for it to crash, when another car appears which behaves in the same fashion. When it comes near you it stops with a jerk. A door is opened, and an occupant asks whether you would like a lift. You look into the car and before you can control yourself you cry out, “Why! There’s no steering wheel!”
“Of course we have no steering wheel!” says one of the occupants rather crossly. “Just think how it would cramp the front seat. It is worse than an old-fashioned gear-shift lever and it is dangerous. Suppose we had a steering wheel and somebody held on to it when we reached a curb! He would prevent the automatic turning of the wheel, and the car would surely be overturned! And besides, we believe in democracy and cannot give anyone the extreme authority of life and death over all the occupants of the care. That would be dictatorship.”
“Down with dictatorship!” chorus the other occupants of the car.
“If you are worried about the way the car goes from side to side,” continues the first speaker, “forget it! We have wonderful brakes so that collisions are prevented nine times out of ten. On our better roads the curb is so effective that one can travel hundreds of miles without going off the road once. We have a very efficient system of carrying survivors of wrecks to nearby hospitals and for rapidly sweeping the remnants from the road to deposit them on nearby fields as a reminder to man of the inevitability.”
You look around to see the piles of wrecks and burned-out automobiles as the man in the car continues. “Impressive, isn’t it. But things are going to improve. See those men marking and photographing the tracks of the car that preceded us? They are going to take those pictures into their laboratories and pictures of our tracks, too, to analyze the cyclical characteristics of the curves, their degree of regularity, the average distance from turn to turn, the amplitude of the swings, and so on. When they have come to an agreement on their true nature we may know whether something can be done about it. At present they are disputing whether this cyclical movement is due to the type of road surface or to its shape or whether it is due to the length of the car or to the kind of rubber in the tires or to the weather. Some of them think that it will be impossible to avoid having cycles unless we go back to the horse and buggy, but we can’t do that because we believe in Progress. Well, want a ride?”
In other words, macroeconomics was all about “steering” the fluctuations in the economy. Fiscal policy was the steering wheel and should be applied for functional purposes. Laissez-faire (free market) was akin to letting the car zigzag all over the road and if you wanted the economy to develop in a stable way you had to control its movement.
This led to the concept of functional finance and the differentiation from what he called sound finance (that proposed by the free market lobby). Sound finance was all about fiscal rules – the type you read about every day even these days. So balance the budget over the course of the business cycle; only increase the money supply in line with the real rate of output growth; etc.
Lerner thought that these rules were based more in conservative morality than being well founded ways to achieve the goals of economic behaviour – full employment and price stability.
He said that once you understood the monetary system you would always employ functional finance – that is, fiscal and monetary policy decisions should be functional – advance public purpose and eschew the moralising concepts that public deficits were profligate and dangerous.
Lerner thought that the government should always use its capacity to achieve full employment and price stability. In modern monetary theory (MMT) we express this responsibility as “advancing public purpose”. In his 1943 article (page 39) we read:
The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound and what is unsound. This principle of judging only by effects has been applied in many other fields of human activity, where it is known as the method of science opposed to scholasticism. The principle of judging fiscal measures by the way they work or function in the economy we may call Functional Finance …
Government should adjust its rates of expenditure and taxation such that total spending in the economy is neither more nor less than that which is sufficient to purchase the full employment level of output at current prices. If this means there is a deficit, greater borrowing, “printing money,” etc., then these things in themselves are neither good nor bad, they are simply the means to the desired ends of full employment and price stability …
This is why I always criticise the mainstream use of fiscal rules as being divorced from a functional context. It may be that a budget surplus is necessary at some point in time – for example, if net exports are very strong and fiscal policy has to contract spending to take the inflationary pressures out of the economy. This will be a rare situation but in those cases I would as a proponent of MMT advocate fiscal surpluses.
But just mindlessly rehearsing the sort of nonsense that you read in Mankiw which proposes fiscal rules that always apply is totally irresponsible.
Lerner outlined three fundamental rules of functional finance in his 1941 (and later 1951) works.
1. The government shall maintain a reasonable level of demand at all times. If there is too little spending and, thus, excessive unemployment, the government shall reduce taxes or increase its own spending. If there is too much spending, the government shall prevent inflation by reducing its own expenditures or by increasing taxes.
2. By borrowing money when it wishes to raise the rate of interest, and by lending money or repaying debt when it wishes to lower the rate of interest, the government shall maintain that rate of interest that induces the optimum amount of investment.
3. If either of the first two rules conflicts with the principles of ‘sound finance’, balancing the budget, or limiting the national debt, so much the worse for these principles. The government press shall print any money that may be needed to carry out rules 1 and 2.
In this Biography of Lerner you read the following (pages 218-19):
In 1943 Lerner published an article, “Functional Finance and the Federal Debt,” that announced a new approach to fiscal policy. (The subject was further developed in his Economics of Control and the Economics of Employment.) He noted that conventional fiscal wisdom was based on the principles and morals of good household management: don’t spend what you don’t have – a tacit reminder that the words “economy” and “economics” are etymologically derived from oikos, the Greek word for household.
Lerner, however, picking up on the summary Keynesian prescription of deficit spending, argued that governments should not be concerned with conventional morality but rather should consider only the results of their actions. The aim of government spending and taxing, he said, should be to hold the economy’s total spending at a level compatible with and conducive to full employment at current prices – in other words, no unemployment and no inflation. In doing this the government should not be concerned with deficits or debt. Second, the government should borrow or repay only insofar as it wants to change the proportions in which the public holds securities or money. Changing this proportion will raise or lower interest rates and hence discourage or promote investment and credit purchasing. If the only question, then, was how to finance a deficit, Lerner advocated printing money. Third, the government should put money into circulation or withdraw (and destroy) it as needed to effect the results called for by the first two principles.
So the only reason a government should issue debt is if it wanted to alter the “proportions in which the public holds securities or money”. It is clearly recognised that the government does not need to raise revenue. Debt and taxation are dimensions of the “steering wheel” and help keep the economy on the road.
In his 1943 article Lerner says (page 355) that the government would only issue debt “if otherwise the rate of interest would be too low”. So you start to understand that the “borrowing” is a monetary operation not a funding necessity. He went further on this theme in his 1951 book when he says (pages 10-11) that the:
… spending of money … out of deficits keeps on increasing the stock of money (and bank reserves) and this keeps on pushing down the rate of interest. Somehow the government must prevent the rate of interest from being pushed down by the additions to the stock of money coming from its own expenditures … There is an obvious way of doing this. The government can borrow back the money it is spending (emphasis in original).
This is one of the fundamental insights of MMT – that the issuing of debt drains excess bank reserves that were generated by the net spending (deficits) in the first place. The government just borrows its one spending back. If it didn’t do that and if the central bank didn’t pay a return on overnight reserves then the interest rate would fall to zero (or some support rate that the central bank did pay).
So two things are learned here: (a) net public spending generates the financial assets which are then borrowed – so debt issuance cannot “finance” (by which we mean allow) government net spending; and (b) deficits do not put upward pressure on interest rates contrary to the crowding out story rehearsed above in Mankiw.
And for those progressives (the deficit-doves) – the “proponents of organized prosperity”, Lerner had this to say in his 1951 book (page 15).
A kind of timidity makes them shrink from saying anything that might shock the respectable upholders of traditional doctrine and tempts them to disguise the new doctrine so that it might be easily mistaken for the old. This does not help much, for they are soon found out, and it hinders them because, in endeavoring to make the new doctrine appear harmless in the eyes of the upholders of tradition, they often damage their case. Thus instead of saying that the size of the national debt is of no great concern … [and] … that the budget may have to be unbalanced and that this is insignificant when compared with the attainment of prosperity, it is proposed to disguise an unbalanced budget (and therefore the size of the national debt) by having an elaborate system of annual, cyclical, capital, and other special budgets.
On the next page (p.16) Lerner addressed the problem of progressives who present their arguments in a conservative way because the public might not understand the fundamentals of functional finance. He says:
The scholars who understand it hesitate to speak out boldly for fear that the people will not understand. The people, who understand it quite easily, also fear to speak out while they wait for the scholars to speak out first. The difference between our present situation and that of the story is that it is not an emperor but the people who are periodically made to go naked and hungry and insecure and discontented – a ready prey to less timid organizers of discontent for the destruction of civilization (emphasis in original).
So way back then Lerner was dealing with the same debates and charlatans as are everywhere today.
Once you understand these ideas then you are well on the way to comprehending the basis of policy design in MMT, which adds a very rigorous stock-flow consistent framework ground in the national accounting identities to the principles of functional finance.
It also helps you realise why the progressives who argue like Gittins are really conservatives.
You might like to read the following references:
Lerner, A. (1941) ‘The Economic Steering Wheel’, University of Kansas Review, June.
Lerner, A. (1943) ‘Functional Finance and the Federal Debt’, Social Research, 10, 38-51.
Lerner, A. (1944) The Economics of Control, New York, Macmillan.
Lerner, A. (1951) The Economics of Employment, New York, McGraw Hill.
Digression: what the hell?
The federal government announced today that it was appointing former (failed) conservative treasurer Peter Costello to the board of the Future Fund which was the fund that Costello, himself created by denying Australia of investment in public infrastructure and full employment. Towards the end of the conservative period in office, they started to purchase financial assets claiming it was salting away the budget surplus.
In fact, it was just spending but rather than create jobs or improve our schooling or health system, they speculated in financial assets. They bought the remaining “public shares” in the privatised Telstra which have since declined in value. They did that to avoid having to sell the shares privately after the second tranche of Telstra shares had brought such losses.
By the end of the conservative’s 11 years in office (10 of them in budget surplus) Australian households had record levels of debt, our public infrastructure including our higher education system was in tatters, and we still had 8.5 per cent of our willing labour resources underutilised (either unemployed or underemployed).
And now the Labor Government has the audacity to appoint the architect of this fiscal abomination to the very totem of his failure.
Read the former Labor Treasurer then Prime Minister (before the conservatives 11 years) comments HERE. He also didn’t get it but at least his outrage to this decision is genuine and supportable.
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Another very interesting and informative post. I think what you argue here and in other posts makes a lot of sense.
I may be missing something (quite possible!), but the way I see it, the cost of public infrastructure investment is not borne by future generations. It is borne by the current generation in the form of a commitment of time and resources to the building of the infrastructure. In an economy operating at full employment, some other productive activity would need to be given up to make way for the construction of the public infrastructure, and society may be trading off some current consumption for greater consumption in the future. But with high unemployment and underemployment, there is little to no trade off, just a commitment of otherwise idle resources.
When capitalists oppose public-sector production and investment, I don’t think it is out of a genuine fear of “government debt”. It is for distributive reasons. Whenever the government spends with newly created fiat money, it alters the distribution of nominal claims on society’s wealth, both directly (someone now has more money) and indirectly (e.g. by boosting employment and undermining capitalists’ control over wages and conditions). Capitalists oppose government activity if they think it will reduce their share of nominal claims on wealth. For instance, if financial capital was really concerned about “government debt” and the “burden of future generations”, it would have been horrified by the bank bailouts. But financial capital is okay with them, and only horrified by the smaller stimulus expenditures. I think financial capital understands perfectly well that deficit expenditure in itself is not a problem (only deficit expenditure that benefits the broader population at the expense of financial capital!), but it pretends it is a problem because fiscal austerity is in its distributive interests.
Affordability only really depends on the availability of time and resources. But, under capitalism, something socially beneficial doesn’t get done just because society can afford it. If capitalists think it is in their interests, it will get gone. If not, it will only get done if capitalists – despite their power and influence – fail to prevent it. In the latter case, they still won’t like it.
I think that conservatives noticed that one of the effects of the “golden age” of “Keynesianism” (not really, but close enough) in the 50s and 60s, when unemployment was virtually nil in most of the industrial world, was the political ferment of the late 60’s. When people have economic security, they start demanding other rights. But if you make sure that everyone is contantly afraid of losing their job, you get a docile workforce that keeps it’s head down and doesn’t make trouble. While I’m not much of a conspiracy theorist, I think the people who pay the politician’s bills have an instinctive knowledge of this. They will latch on to any BS economic theory that gives them cover to push austerity…
Hello Mr. Mitchell,
I read through your post and I must admit that I approach the matter from the point of view of those that preach constraint in government spending. Sorry about that.
You refer to the currency as the Government’s child. I do not disagree. However, the Government is the peoples’ child and one does not desire that the Government act contrary to the peoples’ interests. Yet, this is in fact what happens repeatedly. The Government is entrusted with supplying goods of value and with maintaining the integrity of the money supply. However, it often supplies goods, needed or not, of a poor quality bearing an exorbitant charge. It is usually responsible for periods of chronically elevated inflation in times of unrestrained spending and borrowing, generally at the height of the business cycle when the excessive flow of tax revenues no longer satisfies an ever broadening appetite.
You mention the aims of government, but do full employment and capacity correspond with the aims of the people? I have always thought greater wealth might be a more gratifying objective.
Government debt is fine with me. In fact, all government spending could be debt financed, just as long as it was put to worthy purposes. Hiring large numbers of the unemployed to dig holes in the morning and fill them during the afternoon would not be one of them. The cost of the endeavour would be immense and the yield about nil.
Dear Gary Marshall
Why apologise? I was taught to apologise when I had done or said something wrong. But I also hope you only preach constraint when the government has spent in net terms up to the amount the non-government sector has withdrawn from the expenditure stream such that full employment output is achieved.
I would not have used the word child. It is clear the government is our agent and we want it to do things that advance public purpose. Your description of poor government conduct is not unique. But in most countries we can throw them out and enforce our will. Moreover, I have a good historical understanding and your claim that “usually” bad things happen does not bear up against the facts. Exactly how many years in how many nations has inflation been a major problem since 1940?
You cannot have the greatest wealth and maintain persistent unemployment of productive people. I think if you ask the unemployed what they want 99 per cent will say a job so they can access the wealth generating process. Clearly, persistent unemployment has allowed some people to extract more wealth for themselves at the expense of others which probably is gratifying to them. I see the aims of society to be broader than that.
Government spending does not need to be financed in a fiat monetary system. That is a basic misconception.
Please get a bit more sophisticated in your criticisms than the “digging holes in the morning and filling them back in later in the day”. There are countless examples of productive activity that the unemployed could perform. A classic example in the past is the creation of the Great Ocean Road in Southern Victoria – a huge tourist resource now generating millions – the result of public works schemes. I have also worked in different countries around the world observing public works programs – not perfect but so much better than leaving the people in poverty and without basic infrastructure. I suggest you read a bit more so that you will learn about the relative sophistication of direct job creation programs that are already in place in different nations.
Then you will realise that the industry we call mining – and extol – is about the only activity that digs holes and fills them in again – and leaves massive costs to clean up later.
“You mention the aims of government, but do full employment and capacity correspond with the aims of the people? I have always thought greater wealth might be a more gratifying objective”
Err…………….what? Greater wealth for which people? Not the unemployed obviously.
Hello Mr. Mitchell and others,
I did read through your response and Lefty’s.
It would be of great benefit if a change in the leaders of government compelled a change in the direction of government, but many learn the folly of such thinking. The interests of Government predominate in thought and action, growing in size as quickly as their avaricious hands allow.
Only a rarity of politicians have ever withstood them, and only briefly.
When persons and corporations borrow money, it is generally with devised purpose; For the consequences of failure may be complete ruin.
When Government borrows, it is never truly known whether the benefits justify the costs. Government just does not operate assessing costs and returns in its diverse endeavours. If a success or failure, no one really knows. However, the bill as always is passed along to others.
The 40’s were a bad time with which to make comparisons given the wars and upheavals. The march of government growth through the 60’s, and especially in the 70’s and 80’s exactly corresponds with an ever ascending level of inflation. Money growth without purpose is always inflationary. Only governments can perform the feat with impunity, and perform they did all throughout those years culminating in the 20% rates of the early 80’s.
Full employment is not a rigid yardstick as the percentage or figure is always variable.
With government’s thirst for funds and size, the percentage of one’s income exacted must also rise. The income of one wage earner in a typical family of 4 may have sufficed once to carry the family financially allowing the other parent to remain home and tend to the household and children. Unfortunately, taxes must rise to pay for the expansion of government goods and services. So with a sharply curtailed income, the other parent is forced to leave home in search of income to maintain the home.
This brief explanation may reveal some of the conflicts that arise in how different people and entities may measure full employment or determine their objectives. Governments want to see as many people working and contributing to the revenues of the state. More revenues, more government. With extortionate tax rates, Governments compel contentedly idle people to work, gradually usurping the responsibilities of the home. A large number of people would love to remain and raise their children in the home, but cannot. Not every person perceived as idle will require a job.
If the government truly served the people, then perhaps evaluating programs for benefit would constrain spending and create wealthier households, leaving the inhabitants to live their lives as they please. In this, Lefty may find an answer to his query.
My mention of those employed by government to dig and fill in holes is not an unsophisticated criticism; it is a fact. My point is not that the Government should leave the unemployed idle and impoverished, but rather that it should find some worthy and legitimately productive endeavour that generates a return.
How many politically useful, but financially worthless programs does the government fund or operate? How many government workers could the government release and still perform as it does now? In absence of any investigation, standards, or evaluation, I must conclude there are many and that those employees are performing functions that are nothing more and probably a great deal less valuable than the hole diggers.
Now, if you were to take these veritable idlers and train them to be engineers, doctors, tradesmen in thinly supplied labour markets, then you may have a worthy or at least far better return for the people’s money invested. The example also shows the poor thought and reasoning within the concept of the ‘multiplier effect.’
You say that Government spending does not need to be financed in a fiat monetary system. You have mentioned this repeatedly and I am quite unsure of your meaning. If it be true, then why is there taxation? Why do governments borrow on the markets creating bonds yielding interest for those willing to part with their money?
if absolutely everyone in the Australian economy must acquire $AUSD from someone else first – earn, borrow, tax, steal, – then who or what is the original someone?
If everyone had to somehow get it from someone else first – then what is the source of the $AUSD you are holding?
Think deeply about that before answering.
Dear Gary Marshall
I would suggest you go back to the first blog I wrote in this version of billy blog here and then work through the remaining 298 posts or about 950,000 words since then (you can skip a few guitar concert reviews).
If you still have questions like those above, which I think are answered in detail in those blogs, then I have failed to communicate.
But I think that will clear up a lot of your other issues as well. But to understand why taxes are raised and debt-issued is intrinsic to understanding the operations of the monetary system you live in.
If you still have issues after all that … then we can deal with them – but at least we will all share the same knowledge set.
I thought there may be a short version, but I will go back and read through the suggested article.
I can’t speak for Bill, but I don’t think you need to subscribe to any economic camp to understand how the government is funded. The government is a currency issuer. If you want to know where government money comes from, just look at dollar bill. It says “Federal Reserve Note”. When the government spends a dollar, that dollar does not come from your own pocket, but from the Bureau of Engraving. Rather, the money in your pocket comes from the government, not the other way around. You don’t need to be a chartalist or a post-keynesian, just a person that can overcome their own subconscious prejudice.
The sense that the private sector must “fund” the government comes from a deeply ingrained zero-sum mental model. This model says that for one person to spend, another must go without. Therefore for the government to spend, the private sector must go without. Obviously this model is wrong and is socially harmful — things rarely sum to zero, and spending can be a net benefit. We can all be wealthier, we all can have higher incomes and a higher standard of living. Societies that hold to this zero-sum belief tend not to do very well, in terms of living standards, but still this belief is widely held. This belief is also wrong even within the private sector, because the private sector can grant itself loans without anyone needing to save to “fund” the loan. The granting of the loan creates the deposit that backs the loan. Just like looking at a dollar bill, this would also be obvious if you discarded the zero-sum model and looked at what actually happens to deposits and the monetary aggregates over time. Many of these beliefs have a pre-galilean feel to them; i.e. you can always drop a metal ball and a wooden ball, and see if the heavier ball hits the ground sooner. But people would prefer to hold to their beliefs than to reason and look at data.
But as you point out, the government does tax and borrow from the public. But the only reason the government *needs* to do this is to moderate consumer price inflation and/or business investment. In some cases, both the government and the private sector want to buy up the same goods and labor, and this can cause bidding wars in which prices climb. So the government has tools to suppress the spending power of the private sector:
* Taxes drain the private sector of money.
* Government debt issuance is effectively a bribe to get an investor to not invest his money in the private sector for a period of time.
* The imposition of costs on bank loans, together with other bank regulations limit the the private sector from granting itself loan-based purchasing power.
All these tools can be used to suppress or promote the private sector’s buying of consumption goods, labor, and capital goods. However, there is no need for the government to suppress private sector spending by one dollar for each dollar that the government spends. That is a zero-sum mental model. Rising spending often leads to rising production which in turn can lead to rising incomes and savings. Everyone can benefit.
In general, the government’s use of these tools should be in order to maximize welfare, not to artificially validate the zero-sum model.
Going to specific policy scenarios, when the private sector is trying to pay down debts, the government sector should decrease taxes and issue more currency. The repayment of debt can never cause inflation. Households focused on de-leveraging not only are not competing with the government to buy goods, but they need a steady stream of surplus cash to repay debt. If, on a net basis, households need more cash to save, then that cash must come from the government.
In the same way, if the private sector has bleak investment prospects and is not investing, then it is harmful to try to bribe this sector to not invest by issuing bonds. Bonds should not be issued when the government wants to promote private sector investment.
In the same way, when the public sector does not wish to borrow, or when banks do not wish to lend, government imposed costs on bank lending should be decreased. There is no economic purpose to making borrowing more expensive when people do not want to borrow, and there is harm to increasing the bank costs when banks are in poor financial health.
The goal in all these trade-offs is that the government levers should be used in a way that promotes well-being, not to conform to a false zero-sum world-view. Once you are freed from the zero-sum mental model, you can then get into various debates about the relative trade-offs and consequences of government action, and then decide which camp you want to join.
Nicely said. I have said in the past that modern monetary theory is neither left-wing or right-wing thinking. It is a statement of the way the system functions and what opportunities (and consequences) are available to a government that issues the currency as a monopoly.
What opportunities you pursue and how you feel about the consequences will then disclose whether you are left, right, republican, democrat, labour-ite, liberal, conservative, post keynesian, marxist etc (if these things can be reasonably separated.
The fact I have a MMTist doesn’t make me a supporter of any particular ideology. Of-course, we all support some ideological position but that is separable from my understanding of monetary theory (unless you consider talking about reality an ideology in itself – which doesn’t take you very far).
I did read through your response.
I do not believe in a zero sum world. In fact, you would probably be astounded to learn what I do believe.
There is a problem with your analysis. You are attempting to define currency as equivalent to the stock of money. Currency is certainly money, but not all money is currency.
The source of the error is not yours. It is to be found in every modern economics textbook.
What is the standard definition of money: unit of account, store of value, and medium of exchange. This is not a definition of what money is, but rather what it does. It is a functional definition and one quite worthless for the task.
Imagine me defining water as: boiling at 100 C, or freezing at 0 Celcius.
Currency is money, but it is one component and a small one, comprising in my native land of Canada about 5% of the stock of money in existence. I apologize for using Canada so much, but it is where I hail from. The analysis should apply to any stable western nation with little variation.
There are $50 billion in Canadian dollar notes circulating mostly within Canada. However, there is over $1 trillion in Canadian dollars in existence. That money comprising the other $950 billion or more exists only in bank records. It has no physical existence. It is ethereal money, but it does exist. One just cannot physically hold it.
I shall admit that a number of economists do distinguish between currency, calling it outside money, and ethereal money, calling it inside money. But they do not carry the distinction very far.
There are several differences between these 2 forms in creation and in operation. Most important is that currency or outside money earns no interest, whereas ethereal or inside money does. This is the primary reason that banks and people will hold as little currency as possible, just enough to fulfill their immediate financial obligations.
Attempting to equate currency only works about 5% of the time.
When you say that the dollar the Government spends comes from the Bureau of Engraving, only if its currency. The rest, that ethereal money, is created generally by the commercial banks through the loans process.
Currency is an inferior form of money as it yields no interest. It is a dead loss to any holder, especially a bank. It is a store of value, a medium of exchange, and a unit of accounting, but it does not earn interest.
A bank must pay interest to a person having deposited currency notes, but it can earn no interest upon that currency whilst it sits in vaults. The bank requires currency to satisfy its clients needs, and the less it holds for those purposes the better.
Ethereal or inside money does earn interest. Therefore it is preferred about 19 times out of 20 as the established relationship confirms. In other words, the banks will return currency to the depositor or redeem their liabilities in BofC notes 1 out of 20 times.
If the Canadian Government were to pay its bills in newly manufactured currency rather than ethereal money garnered through taxation or borrowed, it would have a disastrous effect on the value of the Canadian dollar and on the economy.
Suppose Canada’s banks increase the stock of money through the loans process over some term.
After growth in the stock of money of 10%, how much would the demand for currency grow? It should rise proportionally by 10%. If the stock of money moved from $1 trillion to $1.1 trillion, the stock of currency should rise from say about $50 billion to $55 billion.
If the stock of money doubles over some term to $2 trillion, the amount of currency in circulation should also double to $100 billion.
Therefore, if Bank of Canada were to double the amount of currency in circulation by creating and loaning it out, equilibrium in the demand for currency would be restored only when the banks had doubled the stock of ethereal money through the loans process. The inflation rate should be about 100%.
So if the Bank of Canada were to add just $50 billion of currency to the stock of money, the eventual outcome would halve the value of the Canadian dollar.
The Bank of Canada has never dared push currency into the financial markets in absence of demand. Any hint of such a threat would send the financial markets into a panic.
I think our former Prime Minister Jean Chretien as the finance minister oversaw a borrowing of $40 billion in 79 in a $300 billion economy. Thank God they borrowed only ethereal money and did not print currency; for the inflation rate would have been 200%, not 18%.
I agree with most of what you say about zero sum. The quantity of money is variable. It can be augmented through the loans process. But to say that a Bank needs no matching depositor when a borrower comes to collect his funds is wrong. A review of a Bank’s balance sheet operations in discharging the loan will confirm this conclusion. A bank requires money to create money save in the most unusual of circumstances.
Here is what I said to Scott…
Lets say that the Bank has assets and liabilities of $100 each. A borrower comes in seeking a loan at some rate over a 5 year period . It is approved and the assets and corresponding liabilities of the Bank rise by $10, the asset in the form of a loan and the liability in the form of the funds deposited to borrower’s account, to $110 each. Now the borrower arrives to collect his money.
If the Bank has funds, on the asset side money reserves decline by $10 as do liabilities when the borrower takes his money.
If the Bank has no funds, it cannot give the borrower his money. The Bank can either convert an asset to money sending us back one step or it can borrow the funds from some person or organization, i.e. acquire a depositor.
Either way, the funds had better be there when the depositor arrives.
If the borrower issued a cheque on the account, there will be a delay in clearance.
When the time of settlement arrives, the Bank if without reserves would show a money position on its asset side of -$10 for a total asset position of $100. The borrower’s liability would be erased and the total also $100. The Bank must now acquire a depositor, a person, firm, or central bank, to complete payment of the $10 to the claimant bank.
Are we agreed?
That a bank may arrange the financing subsequent to the agreement of terms for the loan matters little. Barring an asset sale, a deposit in an equivalent amount had better be there when the borrower arrives or his cheque is presented for settlement.
So in a loan a matching deposit is created, but equilibrium is maintained only if the borrower never withdraws the money, which seems unlikely.
You can acquire a deposit in the overnight markets, but when the term of a loan is 5 years it is best not to match it with demand funds.
Now, increasing the quantity of money is not automatically inflationary. It depends upon the purpose of the loan. In the 70’s governments borrowed without regard to returns adding enormous sums to the existing stock of money without any beneficial outcome. The result was chronically high rates of inflation.
However, if a company selling 10 units of some product in an economy with an existing stock of money of $100 borrows $100 to expand production to 25 units, is this inflationary? Not at all, the former selling price would be $10 per unit. The subsequent price would be $8 per unit with a stock of money of $200 and 25 units for sale.
Yes, increasing the quantity of money can cause inflation especially when governments are borrowing, but it need not be that way.
My comments upon the lack of any investigation or requirement of a return for government expenditures can be found above and need not be mentioned again. Until this changes, one never knows the value of government supplied goods. However, private firms and individuals generally borrow fruitfully.
It is not up to the Government to decide upon the state of the economy and take appropriate measures to spur or quell growth or lending. The money markets with the interest rate as arbiter already perform this function most ably. Imagine an organization that does not scrutinize itself or its activities for value or returns, squanders immense sums, exacts ever greater sums from others to pay for it all, favours some groups over others, charged with arrogance and corruption telling prudent, thoughtful, financially cautious minded people and companies that it knows best and acts accordingly.
Not reassuring is it.
Dear Gary Marshall
I wonder how many of my early blogs you have yet to read. Much of what you say here is mainstream textbook economics which has very little bearing on how the monetary system actually operates. For example, statements like:
… are total fictions. All government spending is via crediting bank accounts irrespective of other monetary operations that might follow. Taxation and debt-issuance provide no funds to the government to enable it to spend.
Government spending without increasing taxation (draining the purchasing power of the private sector) and/or debt-issuance (draining the bank reserves created by the net spending in the first place) is usually going to stimulate output and employment and sometimes will be inflationary if aggregate demand growth outstrips real capacity.
I think you should realise that I provide the commentary freedom to anyone so that they will engage with the ideas. Your input to date suggests that you have not come to terms yet with what is being discussed here – at the level of first principles. Meagre repetition of first-year neoclassical macroeconomics textbook theory is not engaging with the ideas.
Not an economist, but I take “currency” to mean physical notes and coins.
If only 5% of all “money” in existence is currency, then it seems clear that the vast majority of borrowers coming to collect their money cannot possibly involve – or require – any transferral of currency between lender and borrower.
I am sorry, but I have yet to read any of your posts. RSJ jumped in with a comment and I felt compelled to answer, prematurely.
I shall get to the reading very soon.
In a science the problems and errors are generally to found within the first principles. If they are logical and sound, then what issues should be an easy affair. I spend a great deal of time investigating such principles, examining the rudiments and the assumptions employed in their formation. If one find fault in one such assumption, then all that follows, all the theories and ideas depending upon it, fall with it.
Now if we are agreed on the principles, then all that issue from them will require simple consent. Clearly my commonplace notions found within any introductory economics text conflict with the positions of both RSJ and Scott. Either I am missing something or they are.
I shall read through your disturbing argument that a government blessed with neither funds from taxation nor borrowing can continue to spend as freely. I am sure you have a good explanation.
Absolutely correct. People use cheques, debit cards, electronic transfers via computers and phones. In this age, currency is becoming obsolete. Some people will demand it. Those that want no record of illicit transactions or illegal exchanges, those that do not trust banks, those that continue to use it for small and immediate purchases, and those persons quartered in foreign countries that do not trust the paper issued by their own government.
Gary, I am curious as to how the position outlayed in your last paragraph of your post previous to the one above accords with the events of the past 12 months.
Dear Gary Marshall
I think you will find that what gets taught in macroeconomics textbooks is still based on gold standard thinking. It is hard to expunge that from your thinking if you have been trained in that way. But if you let it go for a while and rebuild your understanding from the way the system actually operates now then I think you will see a different picture.
Of-course, you may still have significantly different policy aims to others but at least these aims will not emerge from a faulty understanding of how our monetary system operates but rather reflect your ideological view of the world, as my policy aims reflect my value position.
And you say:
It is not too disturbing to realise that the government that issues the currency has no revenue-constraint. But you will learn that it cannot “continue to spend as freely” because ultimately, while it has no financial constraint, it does face a real constraint – available resources to purchase. That constraint and how to approach it is what the economic debate should be about – not the falsely constructed financial constraint.
I am getting a better understanding of the idea and the method.
I see connection of precious metals with money historically, but I believe that one can never attach it to a monetary unit. Make one loan and the prescribed illusion falls away.
I agree that Government may create as much money as it wishes since it may freely print up and distribute Government bonds in any amount.
However, creating money without purpose or when the purpose consists of costs that far surpass returns is highly inflationary. Such inordinate borrowing drives those holding that monetary unit to far more stable currencies or to goods retaining value.
The problem is constraint. Where does the Government cross the line? Inflation is a sign that investments are not paying off, that returns do not match costs. The only entity in a country that can borrow without regard to costs and benefits and with impunity is Government.
Since there is no measure of the benefits of Government expenditures or public investments, the great failing of current public finance, how does one ever know whether Government efforts are productive or detrimental?
A business needs a return of 7% to justify an investment. It convinces its bankers to proceed by submitting the varied facts and figures. When has government ever performed a similar exercise?
I’m not sure why the government should be required to generate a financial return on investment? The government has no need to turn a profit, for the same reason that it has no need to “save” money from budget surpluses. If the government must incur liabilities on paper in order for the public to share in various intangible assets (universal access to clean water, for example), then this purely illusory price is a very small to price to pay indeed.
Access to clean water could be accounted a return. Dirty or disease laden water can cause a community grievous harm. The local hospital may be overrun with patients suffering all sorts of water borne maladies. The medical costs, lost work days, etc could be erased with a modest investment in purifying the water.
An idle person will cost the community or nation in welfare costs. An annuity of $10,000 would require an initial investment of $200,000 with an interest rate of 5%. If a person collects $10,000 per year, the community or nation would be better off supplying or lending funds of say $50,000 for training or education up to amend the burden.
Unfortunately, Government does not account the costs and benefits of its expenditures. Revenues arrive through taxation or borrowing and they are spent well or ill. Until Government performs such rudimentary calculations that are so common in our daily lives, none shall ever know the financial benefits of clean water, turning the idle to productive endeavour, or tending to the injured or ailing.
What are the financial costs and benefits of Taxation, the primary means by which Government raises capital for expenditure? No one has ever bothered to examine this important question before. The answer is a simple one. The financial costs are staggering and the benefits nil.
Without such tool and exercise, what method is there of slowing the inexorable growth of stolid, selfish, squandering, uncritical government?
What the Fed did was a fiscal operation. The US Government handed it about $700 billion in US T bills and bonds. The Fed credited the account of the US Government a similar amount. The balance sheet balances. But the Fed had no money save inflationary currency to pay it. The Fed exchanged the bonds with the banks showing loans or assets at face value but in truth of little value in lieu. The amount in the US Government account dwindled over the year, not because it was paid but rather to reflect the diminished value of the assets. The point is that it is the public who shall assume the burden for the bailout, not the Fed or the banks.
I realize there is a different point of view on the purpose of taxation at this blog, but taxes are being raised in the individual states to pay for Government expenditures.
Thanks Gary, but I was actually referring to the events that necessitated the rescue of the financial sector and led to global recession. Seems that financial markets are perfectly capable of catastrophic failure all by themselves.
How do I add a thick vertical gray line if I want to quote you or someone ? Also, is it possible for you to add a “preview” for comments before posting ? Somehow, we tend to notice the typos, grammatical and HTML formating mistakes only after we post.
In the style I designed for the blog you cannot add the grey line as a commenter. I will investigate. You can indent a quote though using the following tags
In terms of the preview, that is a bigger issue and would require quite a bit of programming. If you know of a WordPress-based site that allows that functionality can you send me its WWW address (to my E-mail address) so I can see the theme they are using and I might be able to recode my theme accordingly.
There have been throughout history a few rare, frightening and convulsive episodes in the financial and commodity markets as well as in many other places. One may have excess for only too long before corrective events arrive to root out the imbalances and restore order often hastily and drastically. With these remedial forces in play, the market behaved as it should have.
Whose to blame? Everyone; For we all have sinned.
Some organizations still wish the party to continue. They are borrowing and expending great sums picking up where the chastened others have left off.
Will it cure the malady or just delay the worst of its effects? We shall see.
Mr Mitchell, love your blog. Truly the most informative macroecon blog out there.
I have a couple comments. Would you rather someone dig and fill holes or walk around looking for houses to rob and girls to rape? My point is simply that even menial tasks that pay someone a living wage are more useful than having able bodied people wanting to do something. Surely we can come up with some useful things to employ people at. There is not a dearth of things which need doing but there certainly are a dearth of people looking to start a profit earning business in this environment, and its not because they dont want to earn profit but because there is not enough people to profit off of.
There is only one entity that can create a customer out of thin air, a currency issuer.
You say, “Surely we can come up with some useful things to employ people at.”
I entirely agree. It does not require much imagination to find worthy occupations for the idled and the impoverished.
My question is why Government seems so bereft of that simple imagination?
No issues. It may require you to do a lot of coding or use some standard template which will trouble you since you have managed to give a very clean look to your blog unlike any other blog in the internet. I especially like the comments section here as it is very readable and easy to follow up.
I found a good solution to preview comments: simply make a dummy wordpress blog and use the edit option in the blog creation.
I have been reading through some of the posts regarding government borrowing. I have some problems with it.
The only way for the government to borrow without having to raise money in the capital markets is to have the central bank print up and distribute currency notes. Is this correct?
Suppose the Government needs $10 billion. It can sell Government bonds out in the capital markets which would put upward pressure on interest rates.
Or it can give the bonds to the central bank, which acquires an asset. The central bank can credit the Government’s account for the same amount. The Government spends money handing out cheques. These cheques arrive at the central bank for clearance. The central bank, assuming that any ethereal money received from its currency customers is fully invested in government bonds, will then have to print up and distribute currency notes to pay the bills.
As only a very few will wish to keep the currency notes for reasons mentioned before, they will be returned to the central bank almost immediately. The only way for the central bank to reimburse the currency holders in ethereal money is for the central bank to sell those Government bonds it acquired initially or to transfer title. As the bond title recipients are not financial institutions, they will probably sell the bonds. This action would put pressure on interest rates.
If this be correct, there is no way for the government to use bonds without putting pressure on interest rates.
Dear Gary Marshall
Incorrect. In a fiat monetary system, governments do not have to raise money. Further, the activities of the mint department (printing currency notes) has no functional relationship to the net spending of the national government. You need to read the blog again to refine your understanding of how government operations work.
The sale of government bonds to drain the reserves created by the net spending stops interest rates from falling – which generates a different perspective than saying interest rates are pushed up (the crowding out story). If no bonds were issued, the overnight interest rate would fall to whatever support rate the central bank offered the commercial banks on overnight reserves, which could be zero.
Whatever transactions the central bank and treasury make (government “lending” to itself) are not functionally relevant to anything important. The cheques would arrive at the commercial bank which would record them against the customer as a deposit. The central bank would note that bank reserves have grown. The mint would keep printing currency notes on a daily basis not in the slightest mindful of these cheque-deposit-reserve transactions. If the customer desired to have some currency notes they would withdraw them from their bank. Each day the bank ensures there are enough currency notes to satisfy customer demand. The dynamics are not remotely as you describe.
This is not how the banking operations would work out. The only reason why the central bank would sell bonds after the government had issued cheques and added to reserves is if it wanted to drain some of those reserves to allow it to maintain control of its target interest rate. The excess reserves would be promoting competition in the interbank market (banks wanting an overnight return on the reserves) which would be driving the overnight rate down. So the central bank would then sell the bonds – that is, the orthodox view that the earlier central bank-treasury transactions were “monetising” the deficit ignore the interest-rate operations that the central bank has to engage in to maintain its monetary policy stance. So the bond sales are not discretionary in this case.
However, the central bank could just as easily pay a return on the excess reserves (which is functionally equivalent to selling the bonds), not sell any bonds at all, and still defend its target interest rate. So once again, the bond sales (if that is what the central bank did) would stop overnight interest rates from falling below its target rate. Nothing more than that.
All the usual claims that net public spending drives up interest rates miss the point completely.
You say that when the Government cheque holder deposits his cheque, the commercial bank records the deposit, a liability for the bank. Now the bank holds a government cheque. The cheque was made out to the depositor. It has been cashed and must be submitted for clearance so that the bank may record an equivalent asset to balance its liability to the depositor. To whom is the cheque submitted?
I’m not sure its a lack of govt imagination as much as it is a systemic aversion to having the govt employ people, at least in the US. Canada seems less married to the idea that a govt job is a bad job by definition.
Any such job program, imaginative or not, would necessitate an expanding deficit. Since reading this blog I realize the silliness of fearing a deficit in this low employment environment (it in fact is the ONLY way to add financial assets to the public sphere), but very few Americans read this blog and no republican politician could comprehend it. The only deterrent is political but that is a large deterrent in the US.
When a business employs a person, there is a motive in doing so. If the firm profits from having that person employed, the job continues. If the firm ceases to profit, then the person or the job is eliminated.
Now, in Government there is no such analysis, so one is never sure what returns flow from of having a person employed or from entire programs. There are employees and budgets, but what are the results?
No one fears a deficit when the returns are accounted and known. If the government borrows at 5% and returns on the public investment are 12%, fantastic. If the returns are 2% or -55%, then those silly fears are not so silly. When returns are so meager or even negative, the money is best left in the hands of those who earned it. They know how to generate returns or extract value from their expenditures.
Without justification of expenditures, the people in the US have learned to limit Government as much as possible knowing how much squander and arrogance there is in collection and expenditure. California is one of the wealthiest US states, yet its state government finds itself broke because it cannot raise the capital needed to meet even basic services. No politician will dare raise taxes there. The people of California have learned very well what, “Hello I am from the Government and I am here to help you.” really means.
When Government adopts the means to justify its expenditures, perhaps the resistance will fade away.
If government bond issuance automatically puts upward pressure on interest rates, when we check the history of governments fiscal activity against interest rate movements, should we not expect to see a strong correlation between increases in spending and rises in interest rates. I’m aware that other factors could come into play, but shouldn’t a fairly strongly observable link be obvious in any case?
There should be a strong correlation between Government borrowing and upward interest rate movements.
Looking at the two rather significant cases the past decade or so . . . Japan and the US . . . not much support for the idea (at least among currency issuers with flexible exhange rates). Bill did a blog in late September/early October on Japan regarding this, by the way.
“There should be a strong correlation between Government borrowing and upward interest rate movements”
That’s the thing – there appears not to be. In the archives of this blog are a number of graphs depicting Japan running large fiscal deficits while at the same time, interest rates stayed at or close to zero for years at a stretch. I cannot locate them this morning, perhaps someone will be kind enough to direct you.
This made me curious enough to check the historical situation here in Australia. I cannot post graphs because they were done with pencil and paper but once again, they appeared to bear no sensible relationship to one another. In fact, after 2001 Australian government debt fell until net debt was zero, yet over the same period interest rates went up, up and away.
Until I am given a convincing explanation as to why what actually occurred appears to be unrelated to what commonly accepted theory tells us, then I will continue to conclude that MMT has the correct answer here.
Dear Gary Marshall
The fact that there isn’t should give you cause to consider your priors. Don’t let your theory get in the road of the facts! The only thing that debt issuance does is to stop the rates from falling although there are complications with that along the maturity curve.
Hello Bill, Lefty, and Scott,
I said that Government borrowing should push up interest rates. Now how does one separate what the interest rates would be in absence of Government borrowing from what they are with Government borrowing.
Japan in the 90’s was a highly unusual situation. There was a recession and in fact probably a depression. The Japanese Government had operated a forex skimming operation for years trying to keep the Japanese currency undervalued. The taking in of US dollars and issuance of Japanese yen to exporters created an extended period of inflation, driving up the prices for everything domestically and curbing Japanese purchasing power abroad. When the US went into recession in the early 90’s, so did Japan. Unfortunately, Japan did not emerge from it. The banks were essentially bankrupt without any money to lend and without any desire to call in the mountains of bad loans. The Japanese were fearful of bank collapses and endeavoured to protect their money by putting currency in mattresses if you will or placing it with Government corporations like the Post Office.
The money supply should have declined probably by about 25%. Government borrowing propped up what would have been a period of severe deflation. What brought Japan out of its enduring slump was China. Exports revived the economy, but the dangerous exchange rate mechanism remains. China operates the same skimming operation. Now that their best customer is in recession and perhaps worse, the same bubble and its aftermath that plagued Japan for years will probably cause similar problems for China.
The western economies of the 70’s and 80’s are exemplary for Governments borrowing excessively during the heights of the business cycle creating unprecedented inflation and borrowing rates.
The recent case of the US in which persons rather than Governments borrowed huge amounts of money for the purchases of homes caused an inflated price for homes. What would such mortgage rates have been in absence of such speculative borrowing?
The US Government relied on inordinate tax revenues to fund most of its expenditures recently. Now that the recession has struck, what would have been the interest rates without Government borrowing of $2 trillion? The rates are still positive when they should be negative.
All things being the same, Government borrowing puts pressure on rates just as any borrowing puts pressure on rates. However, it is common for Governments to borrow to excess with impunity as recent events verify.
Do you have an answer Bill for my question regarding a Government cheque clearing?
Gary . . . what you said is what Bill quoted you as saying, which was “correlation.” You can change the question if you wish, but don’t make it sound like we misinterpreted.
All the same, though, your questions and then comebacks (this one in particular) are still at a basic first semester level. You still have not demonstrated that you understand ANYTHING on this site (note that understanding is not the same as agreeing with . . . I am expecting the former from someone frequently posting here, and while the latter would be nice I certainly don’t expect it). For what it’s worth (perhaps nothing), I won’t respond to anything more that you post here until this happens (your choice, obviously). And I note that this isn’t the first site on which people have stopped engaging with you . . . you seem to be the common denominator.
Thank you for a very fine observation.
I do work at a very rudimentary level. The research I do looks at the assumptions upon which a science is based. Most errors in any theory occur within this very small but crucial area that most have no time for. If there is agreement on the fundamentals, there should be agreement on all that follows.
Take for an example, actually my favorite, the geocentric theory in physics some 300 – 400 years ago. It was long the dominant theory in astronomy and physics. The varied theories and special cases would have kept any student busy for decades. There were many problems with the theory. Predictability was impossible as each learned inquirer seemed to have a distinct opinion about where something was to be or not be. Retrogression could not be explained. The theory had little or no relation to the universe it supposedly described.
The theory seemed worthless and it was worthless. It took some lone and mischievous Copernican to come along and turn the entire science on its head. The geocentric theory rested on one assumption: that the earth was the center of the universe. No amount of study of all the geocentric theories could have aided anyone in understanding the universe. The effort was pointless.
Now Bill has made a number of statements that do not accord with the functioning of the financial markets and which I describe as very disturbing. He seems to believe that a government has no need to raise capital for its expenditures. But do these musings have anything to do with the operation of the financial markets. The only way to discern their truthful or erroneous nature is to observe the financial markets and find some correspondence with his assertions.
Does Government raise capital in the financial markets. Yes it does. Does it tax citizens to raise capital. Yes it does. Does it issue cheques to those from whom it buys goods and services? Yes it does. Does it issue cheques to those eligible for funding? Yes it does. Do those cheques clear the banking system? Yes they do. Are they drawn on an account with financial holdings attached to it? Yes they are.
Now, you might say that I should go and read through 1000 pages or posts to get a better understanding of Bill’s argument. I do not understand anything Bill says because it makes no sense to me. It does not accord with the facts as I and just about everyone else in the financial system know them to be.
If Bill is correct in his statement that a government need not raise capital for its expenditures, then all he need do is take a paragraph and explain why the Government maintains bank accounts with money arriving from tax revenues and from borrowing through the sales of bonds. All he need do is explain why the government issues cheques drawn on those accounts for goods and services purchased or for funds dispensed.
Why go through this ordeal when a government need not, according to Bill?
Now I am through my inquisitiveness certainly annoying. You may have read a Socratic dialogue here or there. Have you seen any similarities?
Theories are all very wonderful. People have spent years devising them. As elaborate and ornate as they may be, if the theories cannot describe how a government cheque clears, what good are they?
If the academics in their youth had spent less time absorbing and meekly consenting to the ideas contained within those textbooks and more time observing and digesting what goes on about them, maybe economics would be more a science than the political circus it has become.
Dear Gary Marshall
I have answered the questions you pose over and over again – in both my academic work and in this blog. That is why I referred you to the previous posts. I would not have done that just to indulge your time. The answers are all there and if you were truly inquisitive then you might have taken the time to explore those answers. I am sorry you have not done that and that you continue to construct me as some sort of fool who does not have a grasp on “the facts as I and just about everyone else in the financial system know them to be”.
Your facts are wrong. The financial markets do not operate as you think. That you are ignorant of that is a problem but if you don’t want to read the body of MMT then I cannot do anything about that.
This will be the end of my dialogue with you (sorry) and I will not post any more of your comments if they refuse to engage with the body of material presented here (sorry).
Why does the Government go through the long and laborious process of collecting money from taxation or borrowing, of putting it in bank accounts, of writing innumerable cheques on those accounts, of having the cheques clear and money withdrawn and distributed when it need not do so?
What I describe is fantasy? Governments do not issue cheques, do not collect revenues, do not sell bonds, do not maintain accounts, do not draw down those accounts?
Where in all your 298 posts is the need for this superfluous and expensive cheque clearing operation explained?
Its your blog. Do with it as you please. I do not think I am the only person to have dared question the theory and faced the threat of censorship. I do not think I shall be the last.
When I am ousted for asking questions that elicit no answers, it always means I am on the right path.
Gary . . . breaking my own rule here this once . . . the difference between you and Socrates (obviously not the only one . . . quite an astounding comparison by any measure . . . you give yourself WAY too much credit) is that he actually paid attention to the answers and considered them before going into his next round of questions. If you were to do that as everyone else here that asks questions usually does, there would be no problem. But you don’t. So we are always at square one and we are always left repeating something we’ve already answered or correcting something you’ve (repeatedly) misinterpreted. Your list of questions in your two most recent posts are cases in point . . . very basic misinterpretations that we are tired of endlessly trying to correct as there is no effort on your part to demonstrate you’ve understood . . . again, not necessarily agreed with, but understood . .. our points at even the most remedial level. Again, you are not the Socratic gadfly who is being unfairly censored . . . you are simply the common denominator where individuals have chosen to stop engaging with you here and on other blogs.
I have some quarterly U.S. data from 1953Q2 to 2009Q2, which includes the inflationary period of the late 70s early 80s. I define “government borrowing” as the sum of federal and state local borrowing divided by GDP, and government debt is also deflated by GDP, with quarterly data coming from the flow of funds. I had to average the monthly rate series.
The correlation between government borrowing and the y-y change in the 3 month yield (secondary market) is -.41
The correlation between government borrowing and the y-y change in the 10 year (GS10) is -.31
The correlation between the y-y change in government borrowing and the y-y change in the 3 month is -.42
The correlation between the y-y change in government borrowing and the y-y change in the 10 year is -.21
The correlation between the current debt level and the 3 month yield -.57.
The correlation between the current debt level and the 10 year yield is -.51
The only positive correlation I could find was between borrowing and the 10 year yield, which was +0.31. The correlation between borrowing and the 3 month was 0.08.
There is no meaningful correlation between either government borrowing or debt and CPI.
There is also no meaningful correlation between either household borrowing/GDP or household debt/GDP and either the 3 month or the 10 year rates, real or nominal.
Perhaps this list might be useful for people to keep in their pocket when discussing these issues with others.
Lovely. thank you. the same would apply in Australia (which is a small open economy).
Is there an answer to my question?
I did not see any.
Let us start from the basics. Forget everything you know about Economics from any other place. To not get into the chicken and egg problem, let us assume a new economy closed from the rest of the world and with enough natural resources. I am going to be loose here and try to summarize things and there are so many complications and that is why you see so many posts. Let us say the currency is ψ
The government kickstarts the economy by spending first. Let us say that it pays ψ1m in advance to a production firm. There is a central bank in which commercial banks hold accounts. The government simply instructs the central bank to add money electronically to the production firm’s bank account. The assets of the production firm thus increases by ψ1m. The deposit is a liability for the bank and since the bank is just a middleman in the process, it needs to be compensated. The way it happens is that the bank’s account at the central bank is increased by ψ1m. The deposit of the commercial bank at the central bank is the central bank’s liability. We shall simplify and assume that the central bank and the government are one unit for simplicity.
To make the currency “popular”, the government requires that taxes be paid in ψ. It won’t accept anything else, such as apples for taxes.
The production firm uses the money it has at the bank and pays wages to its employees. This just shifts the name of the deposit and nothing great has happened. The employees get the ψs and start consuming. In the middle of all this, the production firm also takes a loan from the bank to expand its capacity and spend. Let us say that the bank gives a loan of ψ2m. When the loan is handed out, the bank’s balance sheet increases on both sides. It records Loans as assets and deposits of ψ2m as increase in liabilities. Please note it already has an asset in the form of the account held at the central bank worth ψ1m. So after the loan is handed out the assets are ψ3m and liabilities ψ3m.
Now, taxes. If a citizen pays taxes say worth ψ10,000, as a cheque to the government, his account at his bank is decreased by ψ10,000 and the central bank reduces the bank’s account held at the central bank by ψ10,000. Taxes are removed from the system. They do not go anywhere.
You have seen that when a government spends, the private sector’s (banks, firms, citizens) assets increase and at the same time, the government’s liability increases as well. The government has to thus keep spending so that the private sector can save.
Then why tax ? The short answer is that it reduces the spending habits of the citizens. If the government does not tax, citizens will consume more and this will go the the production firms. The production firms will both increase wages and take more loans from the bank thinking that it make more profits. At the same time, its inventories are moving fast and seeing this opportunity, it will increase prices rather than producing more as the former is simpler.
You can see that this can be quite bad for the society. Taxes are thus good for price stability.
As far as bond issuance is concerned – maybe sometime else. Or you may try to search this blog yourself.
Here are 2 links.
The first is a graph of the US Fed Funds rate and the 30 year Mortgage rate. The first from 1950, the latter from about 1970.
The second is a table of cumulative US Federal Government debt. When you compare the percentage increases in debt year to year, the greatest fall within the period at which the 30 mortgage rate hit its peak in the early 80s. Then as percentage government debt increases fall, the mortgage rate falls.
By the figures, 79-80 $80b/$826B; 80-81 $90b/$907b ; 81-82 $150b/$997 ; 82 – 83 $230b/$1142b;
Now there are variables to be accounted. Recessions will bring down general interest rates. Booms will augment them. Tax cuts will spur the economy whereas tax increases will retard the economy. Recessions will cause revenue declines and greater borrowing whereas booms will enhance revenues and decrease borrowing. Size of GDP and rate of Government participation will change. Now offer a tax cut in a recession or increase taxes during a boom, or increase expenditures in a boom offering a tax cut or whatever combination appeals to you, things get complicated. How does one separate the effects of each factor from the overall result?
It is not easy, but in the mid 70’s to the mid 80’s, one really gets the picture.
In the present, US interest rates are historically low in face of a massive wave of US Government borrowing – over $100 billion a month. This is a severe recession that appears to be broadening, not weakening. What if the recession had not occurred and the US Government decided to borrow the amounts it is now, would interest rates have remained historically low?
The rates would have soared along with the inflation rate as all this created money deluged a fully engaged economy.
So your quoted statistics may appear to support your position, but only apparently. A little investigation into the circumstances is required before one can elicit conclusions from figures encompassing broad periods.
I am pretty certain that USGDP growth during the period 1925 to 1950 would average out into a nicely gradual ascending line, until that is one looks at the figures for the individual years.
Of course the government accounts for its spending and its receipts. So what? How does this falsify MMT?
Last time Gary Marshall
Deficit spending 101 – Part 1
Deficit spending 101 – Part 2
Deficit spending 101 – Part 3
Will we really pay higher taxes?
Will we really pay higher interest rates?
Fiscal sustainability 101 – Part 1
Fiscal sustainability 101 – Part 2
Fiscal sustainability 101 – Part 3
Functional finance and modern monetary theory – which is this blog.
And if your questions are not answered then I can never answer them.
To all the other commentators … please let this stupidity go. It is impossible to deal with and just derailing useful discussion.
One last word.
I think that Gary has concluded that if the facts do not accord with the theory, then it must be concluded that the facts are wrong.
Through relentless arguing, a lawyer may convince a jury that black is in fact white. But no matter how sucessful he is at this, it will never actually alter the fact that in reality, black is black and white is white.
All I can say about his argument is: not very reassuring, is it?
To all billy blog readers:
Today I refused to approve further commentary from Gary Marshall until such time that he embraces the arguments that are being presented and shows some recognition of what has been written here by myself and all of the others who are nice enough to comment (pro or con).
Some will consider this censorship. In fact, I censor comments all the time – everyday I delete a lot of spam.
My overall philosophical position is clear. I have a totally open view of what is permissible by way of commentary (pro or con). In fact, I like an argument and if I my work can be shown to be analytically in error then I also like to learn new things.
But to be approved for publication a comment has to engage with the arguments presented. Criticism is fine. Lateral analysis that enriches our understandings is excellent. Real world experience on matters that are discussed is encouraged.
But if a person wants to just repeatedly offer the mantra that appears in first-year mainstream economics texts then they have to show us why we should be reading them over and over again. In other words, the argument presented has to go beyond statements like “governments do not print currency to finance expenditures given the havoc it would cause” etc.
We have to be entertained with an argument about the mechanisms by which government spending is likely to cause havoc – how? under what circumstances? We have to learn exactly why in a fiat monetary system the government has to “finance” anything. It does not but if someone thinks it does then they have to explain that rather eccentric notion in full exploring in depth the operational realities of a fiat monetary system that would require such a situation. It is not enough to repeatedly assert the point and then to go off on another tangent.
There are hundreds of blogs where basic maintream macroeconomic analysis without any critical scrutiny is provided every day. Gary should be at home there. But my blog is not about that at all.
Further, I will always delete comments that fail to heed warnings that the the commentary is repeatedly misrepresenting the arguments being put and when the person making the comments declines to read material that will help them understand the nature of that misrepresentation.
In general, while it is my blog I do see it as a community and a place where we can work out ideas and approach an understanding of how the system functions in a way that is not offered in too many other places. So the input from other people in “the community” is very welcome and appreciated.
I already know that networks are developing as a result of my blog between people who may not have otherwise made any personal links.
Anyway, Gary is banned until he reads the Comments Policy and then shows he can have a reasonable interactive debate in which we respond to feedback.
Hi Bill: I see you have been having exactly the same problems with Gary Marshall as I have been having on our Worthwhile Canadian Initiative blog. His comments here are almost identical to ones posted on WCI, even though you and I have very different views of the way central banks operate. Which shows he does not respond to what you or I (or anyone else) actually says, and is just clamouring for attention. You made the right call.
Thanks for the input. I hated banning him but … our patience was being stretched. It is interesting that he didn’t want to engage with either of our (different) views. Anyway, I guess he will find a soap box elsewhere or even start his own blog.
Now: how are we going to get you to come around and abandon this monetarist curiosity that you have? (smiling).
This is probably a stupid question…
Why not just create a set amount of currency, say one trillion dollars, and let the private and public sector fight over who holds and spends it?
If the country becomes more productive, we’ll see deflation (hooray, things will get cheaper!) and if we sit on our duffs and drink beer all day everything (except maybe beer) will get more expensive.
The government (and the people) could decide that the government gets 10 percent of the wealth each year (they spend it all) or 15 percent or 20 percent, or whatever percent based on the perceived need for infrastructure.
That way, the rules of the game would be fixed.
Or maybe I’m missing something?
My comment is 2 years after you posted this, but I am going to answer anyway in case someone might still be reading this.
The task of governance is to provide full employment. To have full employment, you have to balance government spending, import/export, and private spending.
What you are suggesting is monetary policy: Increase the supply of money to generate desirable effects. Monetary policy cannot increase government spending. It can only create private spending by creating additional long term debts and speculation bubbles. The effects on demand are only marginal. Speculation increases revenues of people who are relatively wealthy. These people only spend a small portion of their income, so they would only increase demand slightly.
That is why government has to use fiscal policy. This can be used to increase the income of small income earners:
* Public jobs
These people spend a large portion of their income on consumption. If the government hires unemployed, then this will help increase private spending. Increased private spending by consumers drives private investment, leading to even more private spending.
The entire point is that governments have to make sure people don’t just sit around and do nothing.
The purpose of government fiscal and monetary policy is to get people to work, not the other way around.
You don’t just give people money and then tell them to drink beer all day long, that would be bad governance.
Mankiw: “The most direct effect of the government debt is to place a burden on future generations of taxpayers. When these debts and accumulated interst come due, future taxpayers will face a difficult choice. They can pay higher taxes, enjoy less government spending, or both, in order to make resources available to pay off the debt and accumulated interest. Or they can delay the day of reckoning and put the government into even deeper debt by borrowing once again to pay off the old debt and interest. In essence, when the government runs a budget deficit, it allows current taxpayers to pass the bill for some of their government spending on to future taxpayers. Inheriting such a large debt cannot help but lower the living standard of future generations.”
Even if you grant Mankiw’s premises, his conclusion does not follow. Many people have pointed that out before. What surprises me is that this specious argument is in a well respected textbook.
Terry Reiber: “Why not just create a set amount of currency, say one trillion dollars, and let the private and public sector fight over who holds and spends it?”
It’s been done, in effect, with the gold standard. The end result, it seems, is depressions.