Can a city or state become a sovereign nation? We know what a sovereign nation is – one that has the capacity to issue its own currency and oblige its residents to pay their taxes in that currency. We also know that a state or city is thus not a sovereign nation because it uses the currency of the sovereign nation it “lives within”. So a state or a city is financially constrained in much the same way as a household. In that context, spending has to be financed either from higher taxes or debt issues which clearly places some limits on what programs a city or state can pursue. Further, a city can go bankrupt (become insolvent) in the local currency whereas a sovereign government cannot. So how might cities solve their infrastructure and social needs when they are so constrained?

I rode my bike 80 kms early this morning (usual Sunday) in the beautiful Autumn weather that Newcastle (NSW) enjoys this time of year. The Pacific Ocean looks superb (although there is nothing surfable in sight – maybe tomorrow morning). The sun was out and we were heading for 26-27 degrees. Then it had to happen. When I returned home I opened this morning’s newspaper and came across an authoritative headline: US faces huge deficit blow-out, with the sub-line “Program cuts, tax hikes likely.” The journalist (added to my bogan list) probably got 0 out of 5 on last night’s quiz. Well the truth is that almost everything the journalist wrote is wrong if he is talking about the real world. Anyway, I thought so. Its that time again. Time to debrief.

Some readers have written to me asking to explain what quantitative easing is. Some of them had heard an ABC 7.30 Report segment the other night which interviewed the Bank of England Governor who outlined the BOE’s plan to “print billions of pounds” as its latest strategy to stimulate lending and hence economic activity in the very dismally performing UK economy. Once again we need to de-brief and learn what quantititative easing actually is. We need to understand that it is not a very good strategy for a sovereign government to follow in times of depressed demand and rising unemployment. We also need to get this “printing money” mantra out of our heads.

This is Part 3 in Deficits 101, which is a series I am writing to help explain why we should not fear deficits. In this blog we consider the impacts on fiscal deficits on the banking system to dispel the recurring myths that deficits increase the borrowing requirements of government and that they drive interest rates up. The two arguments are related. The important conclusions are: (a) deficits introduce dynamics which put downward pressure on interest rates; and (b) debt issuance by government does not “finance” its spending. Rather debt is issued to support monetary policy which is expressed as the desire by the RBA to maintain a target interest rate.

A lot of people E-mail and ask me to explain why we should not be worried about deficits and why they do not have to be financed by debt (even if the government does typically increase its debt when it goes into deficit). So in the coming weeks I will write some blogs to explain these tricky things. First, I will explain how deficits occur and how they impact on the economy. In particular, we have to disabuse ourselves of the notion that when governments deficit spend they automatically have to borrow which then places pressure on the money markets (which have limited funds available for lending) and the rising interest rates squeeze private investment spending which is productive. This chain of argument is nonsensical and is easily dismissed. So this is Deficits 101. Next time I will detail the reason why the central bank issues bonds (government debt).