{"id":14238,"date":"2011-04-22T18:43:15","date_gmt":"2011-04-22T08:43:15","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=14238"},"modified":"2011-04-22T18:43:15","modified_gmt":"2011-04-22T08:43:15","slug":"who-the-cap-fits","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=14238","title":{"rendered":"Who the cap fits?"},"content":{"rendered":"

\t\t\t\tIn his recent New York Times column (April 21, 2011) – What Are Taxes For?<\/a> – continues to engage with Modern Monetary Theory (MMT) but trips up because his mainstream view (dressed up as a progressive) reveals serious flaws in reasoning about the way a fiat currency system operates viz-a-viz the former monetary system based on convertibility via some commodity standard. In this blog I correct some of the analytical mistakes that appear in that article. Krugman concludes by claiming that he is really disturbed by those who don’t get mainstream logic – and is especially upset by “a lot of people with Ph.D.s in economics who can throw around a lot of jargon, but when push comes to shove, have no coherent picture whatsoever of how the pieces fit together”. My only response is to look in a mirror Paul or in the words of Bob Marley ask “who the cap fits”.
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Krugman attempts to come to terms with “why we have taxes in the first place” and says:<\/p>\n

\nThey don’t primarily exist as a way to induce lower private consumption, although they may sometimes have that effect; they are there to ensure government solvency.\n<\/p><\/blockquote>\n

So what type of monetary system are we talking about here? A gold-standard type system with convertibility or a fiat currency system?<\/p>\n

In the former, certainly taxation was required to fund government spending whereas in the latter taxes play an entirely different role not identified here by Krugman, who conflates the two monetary systems and thereby misses the point.<\/p>\n

Please read my blog – Gold standard and fixed exchange rates – myths that still prevail<\/a> – for more discussion on this juxtaposition.<\/p>\n

Also please read my blog – There is no solvency issue for a sovereign government<\/a> – for more discussion about solvency and sovereign governments.<\/p>\n

I will come back to the monetary system distinction in a moment. But Krugman further confuses levels of government.<\/p>\n

He says:<\/p>\n

\nConsider first the taxes raised by, say, the state of New Jersey. Chris Christie doesn’t tax me because he wants to reduce my consumption; he taxes me because NJ needs money to pay its bills. It’s true that in the short run, if we ignore the legal restrictions on state borrowing, he can spend more than the state takes in in taxes; but over the longer run the state must, one way or another, collect enough revenue to pay for its spending.\n<\/p><\/blockquote>\n

This statement is true although rather confusingly written. The points in order are – first, a state government does not issue its own currency and therefore is similar to you and me in the sense they have to fund their spending in that currency.<\/p>\n

Second, there is no financial reason why the US states have to run balanced budgets by law. That is just a conservative constraint. The reality they face as a non-currency issuing spender is that they have to get the currency they spend from somewhere – either by imposing taxes via various tax bases or by issuing state bonds.<\/p>\n

There are several propositions that guide the way the state should mix its debt and tax funding. First, recurrent spending should be met via recurrent funding (that is, taxes). Second, capital works spending should be funded by borrowing because it more correctly matches the benefits from the services gained from the new public infrastructure to the generations that will pay for it. Forcing the current generation to pay for bridges, for example, which will deliver benefits for many years, is unfair. So state governments should run deficits equal to their capital works program over the long-term and fund them with appropriately structured debt maturities.<\/p>\n

So the statement that in the “longer run the state must, one way or another, collect enough revenue to pay for its spending” where revenue in context is tax revenue is not a sensible description of prudent public finance at the state government level. The reality is that the “long run” is not a very useful construction here.<\/p>\n

A better way of thinking about it is that state governments transcend generations and must, in part, ensure the “costs” of its service provision are fairly prorated across those generations. As noted above that suggests that deficits should fund the capital budget and the “burden” of the debt servicing be shared between now and later.<\/p>\n

Please read my blog – When governments are financially constrained<\/a> – for more discussion on the intrinsic constraints facing a state government in a federal system.<\/p>\n

Note the term – “intrinsic constraints” – by which I mean constraints that arise from the design of the current monetary system. A state government has no choice but to raise taxes and issue bonds to fund its activity. Yes, it can sell off assets but that process is ultimately finite and not worth considering.<\/p>\n

But when we come to a fiat currency-issuing government – such as the federal government in the US, Australia, the national government in the UK etc – things are entirely different. Here the difference between “intrinsic constraints” and “voluntary constraints” becomes very important.<\/p>\n

Krugman has a go at detailing the difference but ultimately makes a hash of it:<\/p>\n

\nDoes the same thing hold true for the federal government? Well, the feds have the Fed, which can print money. But there are constraints on that, too – they’re not as sharp as the constraints on governments that can’t print money, but too much reliance on the printing press leads to unacceptable inflation. (Cue the MMT people – but after repeated discussions, I still don’t get how they sidestep the issue of limits on seignorage.)\n<\/p><\/blockquote>\n

It is not just a case of there being less “sharp” constraints on governments that issue currency relative to “governments that can’t print money” (note I don’t use the mainstream terminology “printing money” because it is very misleading with respect to how government spending occurs).<\/p>\n

The constraints are of a totally different dimension. Political constraints aside (and I am not suggesting these are unimportant – more later), the constraints on a state government are financial and real. Whereas a sovereign government – by which I mean one that has the monopoly rights to issue the currency in use – only faces real constraints.<\/p>\n

What do I mean? Answer: a sovereign government can always<\/strong> purchase goods and services that are available for sale in the currency it issues without needing to “raise revenue” or “borrow funds”. It cannot buy what is not available for sale. A state government may not be able to buy from the available array of goods and services if it has exhausted its tax base and investors refuse to buy its debt.<\/p>\n

The former is a real constraint the latter a financial constraint. The dynamics of each is very different and very significant in terms of defining the opportunities available each government.<\/p>\n

Next – “too much reliance on the printing press leads to unacceptable inflation” – is a typical statement that you will find in any mainstream (neo-liberal) macroeconomics textbook. It is not the sort of statement that a progressive with a deep understanding of the monetary system would make.<\/p>\n

The correct statement is that too much nominal spending (aggregate demand) relative to the real capacity of the economy to respond by producing real goods and services will generate inflation.<\/p>\n

The problem is that mainstream macroeconomics, which Krugman is just repeating here, considers that the impacts of fiscal policy vary according to the way in which the government “funds” itself.<\/p>\n

Lets state the problem up front so you can follow the explanation a bit more easily – Bond sales do not drain demand.<\/p>\n

The mainstream macroeconomic textbooks all have a chapter on fiscal policy (and it is often written in the context of the so-called IS-LM model but not always).<\/p>\n

The chapters always introduces the so-called Government Budget Constraint that alleges that governments have to “finance” all spending either through taxation; debt-issuance; or money creation. The point overlooked is that government spending is performed in the same way irrespective of the accompanying monetary operations – governments just credit bank accounts (or issue cheques which amounts to the same thing).<\/p>\n

The textbook argument claims that money creation (borrowing from central bank) is inflationary while the latter (private bond sales) is less so. These conclusions are based on their erroneous claim that “money creation” adds more to aggregate demand than bond sales, because the latter forces up interest rates which crowd out some private spending.<\/p>\n

Money creation is also called seignorage<\/em> in the textbooks (and this is a term Krugman uses above).<\/p>\n

Most mainstream macroeconomics textbooks have a section on the dangers of “printing money”.<\/p>\n

In Macroeconomics First Edition<\/em> (1997) – written by the current IMF chief economist Olivier Blanchard), we read (page 572):<\/p>\n

\nMoney creation – is the ultimate source of inflation – is one of the way in which the government can finance its spending. Put another way, money creation is an alternative to borrowing from the public or raising taxes.<\/p>\n

Technically, the government does not “create” money to pay for its spending. Rather, it issues bonds and spends the proceeds. Some of the bonds are bought by the central bank, which then creates money to pay for them. But the result is the same: Other things equal, the revenues from money creation – that is, seignorage<\/em> – allow the government to borrow less from the public or to lower taxes.\n<\/p><\/blockquote>\n

Most of the discussion in this section of that textbook and all other related textbooks relates to convertible currency systems and has only limited applicability to a fiat currency system.<\/p>\n

From the perspective of analysing the relationship arising from transactions between the government and non-government sectors – the central bank and the treasury are more appropriately considered part of the consolidated government sector notwithstanding the claim by mainstream economists that the central bank is a separate entity.<\/p>\n

Please read my blog – The consolidated government – treasury and central bank<\/a> – for more discussion on this point.<\/p>\n

The more important point is that the “money creation” in this sense does not a”allow the government – in any technical sense – to borrow less from the public or to lower taxes” if the government is truly sovereign. It might politically allow that but from the perspective of trying to understand the intrincic (technical) characteristics of the fiat monetary system this description is wrong.<\/p>\n

A sovereign government is never revenue constrained because it is the monopoly issuer of the currency.<\/p>\n

The mainstream depiction of the “funding” necessities of a government are a left-over from the gold-standard, convertible currency monetary system which ended in 1971.<\/p>\n

Earlier on in his textbook, Blanchard (Chapter 21-1) says:<\/p>\n

\nA government can finance its deficit in one of two ways.<\/p>\n

It can do it in the same way that you or I would, namely by borrowing … But it can also do something that neither you nor I can do. It can, in effect, finance the deficit by creating money … with central bank co-operation, the government can in effect finance itself by money creation. It can issue bonds and ask the central bank to buy them. The central bank then pays the government with money it creates, and the government in turn uses that money to finance its deficit. This process is called debt monetization<\/strong>\n<\/p><\/blockquote>\n

A sovereign government only gives the impression that it is “financing” its spending. It voluntarily erects a wall of institutional complexity – accounting structures regulating the relationship between the central bank and the treasury; rules about debt limits; etc – which lead the uninformed to think that these are intrinsic financial aspects of the monetary system rather than ideological\/political constructs to give succour to conservative thinking.<\/p>\n

Ultimately, this ludicrous account of “debt monetisation” amounts to a government borrowing from itself. More importantly, the depiction is problematic.<\/p>\n

Please read the suite of blogs – Deficit spending 101 – Part 1<\/a> – Deficit spending 101 – Part 2<\/a> – Deficit spending 101 – Part 3<\/a> – for more discussion about why a central bank which does not pay interest on excess private bank reserves and targets a positive interest rate cannot “debt monetise”.<\/p>\n

Once you understand that argument – you will also understand the role that debt issuance plays in a fiat currency system. Clue: it doesn’t fund anything (in an intrinsic sense). Rather it provides the central bank with the capacity to drain excess reserves to ensure the demand and supply for overnight funds is consistent with short-term interest rate it is targetting.<\/p>\n

Blanchard cheats his students by claiming that under a system of “money creation” the budget deficit is equal the change in the money supply. In fact that is not true. The correct statement is that the monetary base expands. The central bank has no control of the money supply. While his substantive analysis is based on this lie, he does acknowledge in an obscure footnote (page 430) that the analysis is wrong but then qualifies it by saying it “does not play an important role in the arguments that follow”.<\/p>\n

The point is that it does play a very important role because it helps him mount a case that (Section 21-3) “the need to finance a budget deficit can lead not only to high inflation<\/em>, but also, as is the case during hyperinflations, to high and increasing inflation<\/em>.”<\/p>\n

This suggests to students that deficits are dangerous because they are inflationary and it has to do with printing money. All these associations are false.<\/p>\n

Certainly deficits can be inflationary under the conditions outlined above but the impact has nothing to do with money creation or borrowing.<\/p>\n

Private investment financed by credit-creation in the private banking system can create hyperinflation. An out of control government which pushed nominal demand beyond the real capacity of the economy – and keeps on doing that – will generate hyperinflation. So what?<\/p>\n

The point is that is not an intrinsic outcome of budget deficits.<\/p>\n

All these claims are without foundation in a fiat monetary system and an understanding of the banking operations that occur when governments spend and issue debt helps to show why.<\/p>\n

What would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a budget deficit without issuing debt? This is Krugman’s seignorage option and he claims that “the MMT people” sidestep “the issue of limits on seignorage”.<\/p>\n

First, as a academic developer of MMT I have never sidestepped the possibilty that excessive nominal demand expansion will be inflationary. It is front-stage in all my writing and that of my colleagues. Does Paul Krugman actually read the primary academic literature written by MMT developers?<\/p>\n

In my earlier – Letter to Paul Krugman<\/a> – I raised the issue of good scholarship which, in part, requires a person to faithfully represent the ideas they are criticising rather than falsely associate a school of thought with a set of flawed propositions.<\/p>\n

Second, under this scenario, like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.<\/p>\n

The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made.<\/p>\n

Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability\/equity entry on their balance sheet).<\/p>\n

Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.<\/p>\n

This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management. The aim of the central bank is to “hit” a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.<\/p>\n

When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target.<\/p>\n

Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.<\/p>\n

There is no sense that these debt sales have anything to do with “financing” government net spending. The sales are a monetary operation aimed at interest-rate maintenance.<\/p>\n

So M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. It is this result that leads to the conclusion that that deficits increase net financial assets in the non-government sector.<\/p>\n

What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.<\/p>\n

The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).<\/p>\n

There is no difference to the impact of the deficits on net worth in the non-government sector.<\/p>\n

Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.<\/p>\n

However, the reality is that:<\/p>\n