I read an article in the Financial Times earlier this week (September 23, 2023) -…
Many readers have asked me to explain why social security and pension schemes run by national governments can never become insolvent. Some have heard me commenting on the radio recently about this. In the current recession, where automatic stabilisers are pushing the budget back into deficit to dampen the fall in aggregate demand there are now renewed cries that social security funds around the World are likely to become insolvent. There are the familiar howls that all the “debt” that is being built up as governments go into deficits (mostly because they have been dragged into them by the cycle) will require huge future tax burdens that will undermine the capacity of governments to deliver adequate social security and health care systems. I think its time to de-brief again. The short answer to these claims is: sovereign governments can always fund social security in their own currency. Always, always, and even always.
National social security systems can never become insolvent if the government has sovereignty in its own currency. Further, the pursuit of budget surpluses as a means of accumulating ‘future public spending capacity’ undermines the capacity of the economy to provide the resources that may be necessary in the future to provide real goods and services of a particular composition desirable to an ageing population.
A dominant theme used by governments, business lobbyists, and economists to justify the continued pursuit of budget surpluses has been the so-called intergenerational (IGR) issues. Simply put, it is claimed that a number of federal programs (such as health, social security, and education) are sensitive to demographic factors and with population ageing, the budget ‘blow out’ will be unsustainable. Before the US became bogged down in crisis, the US Government was trying to make a case for the inevitable privatisation of the US social security system as a means of keeping it solvent. Similarly, in Australia, the so-called intergenerational debate was central to the previous federal regime’s justication for pursuing budget surpluses.
The IGR argument is simple: (a) the budget cannot be allowed to reach the projected level because the increasing public debt would push interest rates up and ‘crowd out’ productive private investment; (b) increasing debt will also impose higher future taxation burdens for our children which will reduce their future disposable incomes and erode work incentives; (c) the economy must produce more jobs and people must work longer to accumulate more funds to finance their own retirements; and, sometimes, (e) higher levels of immigration are required to reverse the ageing bias in the population.
Rudiments of monetary macroeconomics
In early blogs in my Debriefing 101 series I have established the following principles. They are worth remembering always when dealing with mainstream economics debates. A full academic exposition is covered in my recent book Full employment abandoned. Here is a summary of the rudiments that will allow you to understand how a modern monetary economy works which will help us see the flaws in the logic (and economics) used by IGR proponents.
- Modern monetary economies use fiat currencies within a flexible exchange rate system, which means that the monetary unit defined by the sovereign government is convertible only into itself and not legally convertible by government into gold as it was under the gold standard, or any real good or service. The currency of issue is defined as the only unit that which is acceptable for payment of taxes and other financial demands of the government of issue.
- Government spending is not revenue constrained. Unlike the government of issue, a private citizen is constrained by the sources of available funds, including income from all sources, asset sales and borrowings from external parties. Government spends simply by crediting a private sector bank account at the central bank. Operationally, this process is independent of any prior revenue, including taxing and borrowing. When taxation is paid by the private sector cheques (or bank transfers) that are drawn on private accounts in the member banks, the RBA debits a private sector bank account. No real resources are transferred to government. Nor is government’s ability to spend augmented by said debiting of private bank accounts.
- A household, the user of the currency, must finance its spending, ex ante, whereas government, the issuer of the currency, necessarily must spend first (credit private bank accounts) before it can subsequently debit private accounts, should it so desire. The government is the source of the funds the private sector requires to pay its taxes and to net save (including the need to maintain transaction balances), making government solvency in its currency of issue a given and a non issue.
- National income accounting defines the government deficit (surplus) as equal ($-for-$) to the non-government (residents and non-residents) surplus (deficit). In aggregate, there can be no net savings of financial assets of the non-government sector without cumulative government deficit spending. In other words, the only entity that can provide the non-government sector with net financial assets (net savings) and thereby simultaneously accommodate any net desire to save and thus eliminate unemployment is the government.
- The systematic pursuit of government budget surpluses is necessarily manifested as systematic declines in private sector savings. Pursuing budget surpluses is necessarily equivalent to the pursuit of non-government sector deficits.
- Unemployment occurs when the private sector, in aggregate, desires to earn the monetary unit of account, but doesn’t desire to spend all it earns, other things equal. Accordingly, unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.
- The central bank necessarily administers the risk-free interest rate and is not subject to direct market forces. The central bank can choose to leave it at 0, regardless.
- Government debt functions as interest rate support and not as a source of funds. When the government spends there are substantial liquidity impacts in the banking system. Budget deficits operationally place downward pressure on short-term interest rates because they will eventually, presuming the increased private demand for cash is less than the injection, manifest as excess reserves (cash supplies) in the reserve accounts the commercial banks keep at the central bank for clearing purposes. Exchanges between reserve accounts in settlement sum to zero in terms of the system-wide balance and so in net terms the money market cash position is unchanged. The system cash position (excess reserve balances) have crucial implications for central bank monetary policy, which targets the level of short-term interest rates.
- A fiscal deficit results in a system-wide surplus, after spending and portfolio adjustment has occurred. The commercial banks will be faced with earning the lower default return on surplus reserve funds which will put downward pressure on the cash rate. If the central bank desires to maintain its current cash (target) rate then it must ‘drain’ this surplus liquidity by selling government debt. So government debt does not finance spending but rather serves to maintain reserves such that a particular cash rate can be defended by the central bank.
- The concept of ‘debt monetisation’ is a non sequitur. Once the cash rate target is set, the central bank should only trade government securities if liquidity changes are required to support this target. Given the central bank cannot really control the reserves then debt monetisation is strictly impossible.
The debriefing – the IGR fallacies
Financial commentators often suggest that budget surpluses in some way are equivalent to accumulation funds that a private citizen might enjoy. Accordingly, accumulated surpluses are allegedly ‘stored away’ for the future which will help government deal with increased public expenditure demands that may accompany the ageing population.
The IGR lobby believes that ‘taxpayers’ funds’ will be squeezed by the ageing population. But, as we have seen above, the notion that taxpayers fund ‘anything’ is misleading. Taxes are paid by debiting accounts of the member commercial banks accounts whereas spending occurs by crediting the same. The notion that debited funds have some further use is nonsensical. When taxes are levied the revenue does not go anywhere. The flow of funds is accounted for, but accounting for a surplus that is merely a discretionary net contraction of private liquidity by government does not change the capacity of government to inject future liquidity at any time it chooses.
The mainstream economic intertemporal analysis that deficits lead to future tax burdens is also problematic. The problem is that the federal budget is not really a ‘bridge’ that spans the generations in some restrictive manner. Each generation is free to select the tax burden it endures. Taxing and spending transfers real resources from the private to the public domain. Each generation is free to select how much they want to transfer via political decisions mediated through political processes.
When I say that there is no financial constraint on federal government spending I am not, as if often erroneously claimed, saying that government should therefore not be concerned with the size of its deficit. I would never advocate unlimited deficits. Rather, the size of the deficit (surplus) will be market determined by the desired net saving of the non-government sector. This may not coincide with full employment and so it is the responsibility of the government to ensure that its taxation/spending are at the right level to ensure that this equality occurs at full employment.
This insight puts the idea of sustainability of government finances into a different light. What we know is that if the national government continues to run budget surpluses to “keep government debt low” then it will ensure that further deterioration in non-government savings will occur until aggregate demand decreases sufficiently to slow the economy down and raise the output gap.
This is in part goes back to the origins of the current financial crisis.
Clearly the goal should be to maintain an efficient social security and health systems. Clearly the real health care system matters by which we mean the resources that are employed to deliver the health care services and the research that is done by universities and elsewhere to improve our future health prospects. So real facilities and real know how define the essence of an effective health care system.
How much a national government devotes to social security and health care reflects political choices rather than government finances.
By achieving and maintaining full employment via appropriate levels of net spending (deficits) the Government would be providing the best basis for growth in real goods and services in the future. In a fully employed economy, the intergenerational spending decisions come down to political choices sometimes constrained by real resource availability, but in no case constrained by monetary issues, either now or in the future.
The debriefing – accounting illusions
Some might get confused by the the accounting structure that a particular government overlays on the spending and taxing flows that support a social security scheme. For example, the US Social Security Administration has two separate funds which underpin its social security system. First, the Old-Age and Survivors Insurance Trust Fund is the accounting device that the US government uses in relation to the payment of future retirement benefits. Second, the Disability Insurance Trust Fund is the accounting device that the US government uses in relation to the payment of disability support pensions.
The US system is referred to as pay-as-you-go system because employed workers pay into the funds during their working lives and retirees etc draw payments from the fund when eligible.
So while there are spending and taxation flows occurring, this accounting overlay creates an illusion that the two (the workers’ contributions and the social security payments) are causally related. They are not.
The contributions are just taxes that the US government levies. They don’t actually fund anything. They drain disposable income and result in net financial assets held by the private citizens being destroyed forever. The fact that they are recorded against the Social Security Trust Fund for accounting purposes is irrelevant. The fund is just an accounting record of the payments. There is no store of dollars sitting somewhere as a result of the taxation flows.
The fact that the fund might hold financial assets which seem to be bought with the excess receipts over outgoings is another source of illusion (and confusion). The financial assets it holds are purchased with US government spending, which of-course, is not revenue-constrained.
Additionally, the social security payments are just another type of US government spending. The spending comes from political decisions to provide a certain level of social welfare in the US and involves the Government crediting bank accounts of recipients on a regular basis in US dollars.
It is crucial, if you want to understand the underlying monetary economics involved, not to get seduced by the illusions created by the accounting structures which sit on top of the essential monetary operations.
The Euro zone dilemma
I was reminded of this dilemma when I read an article in the Irish Times on Friday (March 13, 2009) which carried the headline “Social Insurance Fund to run out this year, committee told”. Its the IGR debate for sure but with a complexity.
In my view, governments who went into the Eurozone, effectively ceding their currency monopoly to the European Central Bank (ECB) in Frankfurt but retaining fiscal responsibilities for their individual nations were very foolish. In effect, the individual nations in the Eurozone reduced their status from that of sovereign government to that equivalent of a state government in a federal system (such as Australia and the US). The import of this is that they are no longer sovereign in the Euro and via the ridiculous Stability and Growth Pact (SGP) they limited their capacity to engage in any fiscal policy necessary to maintain full employment.
The governments should have either, not gone into the Eurozone or, alternatively, ceded their fiscal responsibilities to a European government which would then work in tandem with the ECB as one consolidated government unit. That way the whole zone would bring together the currency monopoly with fiscal responsibility and be able to use fiscal policy progressively to achieve full employment.
But the truth is that as a “state government” the Euro countries have to finance their fiscal outlays either with local taxes or borrowing. They are not like the US or Australian governments which are sovereign in their own currencies.
Once again, there are accounting overlays. Ireland’s Social Insurance Fund is structured into two accounts: (a) a current account managed by the Minister for Social and Family Affairs which collects contributory payments from those in employment and disburses social insurance payments to the unemployed; and (b) an investment account managed by the Minister for Finance, which is an investment (savings) fund for non-recurrent balances. This all seems to me to be a simple enough accounting system.
So like many countries, Irish workers make Pay Related Social Insurance (PRSI) payments into the fund. The Irish Government then makes various transfers to individuals which cover unemployment benefits, State pensions, maternity benefits and redundancy and insolvency payments. The accounting structure used to manage this Government spending is peripheral to the fact this is Government spending offset in part by the PRSI (a tax) that the workers pay in. Any shortfall has to come from additional government spending.
The PRSI (and related Health Contributions) are still to be considered taxes that the Irish government levies. But in the Irish case they represent revenue which supports spending net of debt issuance. So because the Irish government ceded their currency sovereignty to the ECB as part of it entry into the Eurozone means that this revenue does provide spending capacity.
It remains that fact that this revenue is recorded against the Social Insurance Fund for accounting purposes is irrelevant. The fund remains an accounting record of the payments received. The revenue raised could be used to support spending anywhere in the public budget. Further, the Irish government could use revenue from other taxes to fund the social security obligations as well as raise debt up to the limit prescribed by the constraining SGP.
The spending also still comes from political decisions to provide a certain level of social welfare in Ireland and involves the Government crediting bank accounts of recipients on a regular basis in Euro. But it the latter fact that makes all the difference – all transactions are in Euro and the Irish government is not sovereign in that currency. Bad luck for them. So at some point it would either have to break the SGP limits on debt or raise taxes across the board to fund shortfalls in its social security obligations. Alternatively it could just re-define the social security obligations downwards.
Either path is deflationary and reduces the standards of living of Irish citizens. If I was one of them I would be demanding the Government exit the Eurozone immediately and enjoy the status of such countries as Denmark and Sweden (being EU countries) and Norway none of who took the foolish decision to enter the Eurozone.
Hope that clears this issue up for you. I will have more debriefings on these tricky subjects in the future.