{"id":6891,"date":"2009-12-25T16:13:14","date_gmt":"2009-12-25T06:13:14","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=6891"},"modified":"2009-12-25T16:13:14","modified_gmt":"2009-12-25T06:13:14","slug":"on-voluntary-constraints-that-undermine-public-purpose","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=6891","title":{"rendered":"On voluntary constraints that undermine public purpose"},"content":{"rendered":"

\t\t\t\tIt was a very quiet day at the office today. The day started out pretty much as normal – a bit of a surf down at Nobbys Beach<\/a> in small waves with a few of the regulars out. Then as I was driving to work I wondered where everyone was. Anyway, an easy drive. Then I noticed there were no E-mails, no newspapers, no-one at the office … and only one Twitter from Sean Carmody saying he was going off-line for the day. Maybe this is my big chance to take control of economic policy and fix the current malaise? That would be good. There would be some legislative changes immediately. The first I would make (for the US) was the topic of a report in yesterday’s Wall Street Journal (December 24, 2009) which noted that the US Congress<\/a> had raised the debt ceiling to allow the US Treasury to borrow through to Fedruary 2010. Hmm, get rid of that legislation as a first step. Then on we would go.
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\nThe WSJ article reports that “in nearly its final act of the year, the U.S. Senate on Thursday approved a $290 billion increase in the nation’s borrowing limit, a move that sets up a contentious debate about the federal government’s largesse early in 2010.”<\/p>\n

The article notes that:<\/p>\n

\nTreasury officials had warned that the current limit of $12.1 trillion was close to being breached. In light of this warning, Senate lawmakers were left facing no choice but to increase the debt limit before they began the holiday recess.<\/p>\n

An increase in the debt ceiling is largely symbolic as it represents money already spent by the federal government. In the unlikely scenario where it was ever breached, however, there would be significant consequences for the financial markets. The federal government would be forced to default on its obligations, and could lose its top credit rating, having to pay much higher interest rates as a result.\n<\/p><\/blockquote>\n

They also added later on that there will be “another debate before the end of February on the nation’s addiction to red ink.” So no bias in that reporting eh! Not!<\/p>\n

Here is another snippet:<\/p>\n

\nFacing what is widely expected to be a tough mid-term election in November next year, Democrats want to avoid drawing the public’s attention to the profligacy of the federal government. President Barack Obama will espouse his dedication to fiscal restraint in the annual State of the Union address at the end of January, and may reveal proposals to rein in federal spending.\n<\/p><\/blockquote>\n

The Republicans are aslo responding by planning to introduce new measures to “restrain the federal government’s ability to spend. These include discretionary spending caps, a move to strip out already-committed funding from the fiscal 2010 budget and the creation of a commission to investigate longer-term solutions to the debt issue.”<\/p>\n

When you read stuff like that you wonder what planet we are living on. The US is in the throes of its worse economic downturn since the Great Depression. Like … unemployment is over 10 per cent and the US Bureau of Labor Statistics<\/a> estimates its broader measure of labour underutilisation is around 17 per cent.<\/p>\n

GDP (that is, national income generation) which now growing again fell by around 6.5 per cent last year, exports have collapsed (something like down 24 per cent on the peak).<\/p>\n

Consumer spending fell by around 4.5 per cent and household wealth plunged. Business investment fell by around 20 per cent last year and the residential housing market collapsed.<\/p>\n

We could go on. The automatic stabiliser response alone that is built into the US federal budget has been huge as tax revenues collapsed.<\/p>\n

What do the commentators really think would have happened if there had have been tight fiscal rules in place preventing any (or only some) discretionary response in net spending? The economy and the rest of the world economies would have melted.<\/p>\n

To call the fiscal response an addiction to “red ink” or “profligacy” shows how ridiculous the mainstream economics commentary has become.<\/p>\n

The conservatives (who these WSJ journalists just parrot) who want to further constrain deficit spending would even have the government legislate to stop the operation of the automatic stabilisers. That is what fiscal rules aim to do in general.<\/p>\n

The rise in unemployment in the US would have been so great had they done this that social instability would have been likely. It is clear that the fiscal response has been too small and more stimulus is required to get the labour market working again. It is also clear that some of the stimulus has been ill-directed. I am also excluding the stupid TARP from this assessment – that is separable from the fiscal stimulus.<\/p>\n

Anyway, I have been interested in this notion that we have established voluntary rules that constrain our governments from acting in our best interests and then we undermine their ability to act within those rules by saying that the voluntary constraints are severe enough.<\/p>\n

Both forms of logic – that now pervade the public debate – show how stupid humanity is.<\/p>\n

Anyway, the legislation the Congress were amending yesterday dates back to the Liberty Bonds era of the First World War. The Second Liberty Bond Act of 1917 P.L. 65-43, 40 Stat. 288, enacted September 24, 1917 and is currently codified as amended as 31 U.S.C. \u00a7 3101 was the first move to place a public debt limit on government in this way. The Second Liberty Bond Source Book<\/a> is a great reference.<\/p>\n

The Liberty Bonds were issued to prosecute the First World War. During the Civil War, for example the government had to deal with a declining tax base and difficulties in raising borrowing (as the economic base collapsed), and in the end, starting issuing “greenbacks” to allow it to keep spending.<\/p>\n

Historians will recall that serious inflation emerged during this period. By the end of 1863 prices had risen by 13 times (Source<\/a>). The inflation was no surprise given the collapse of the production capacity. A modern variant of that is Zimbabwe which I discuss in this blog<\/a>.<\/p>\n

The point is that spending without bond issuance is not inevitably inflationary as long as there is a productive capacity in place to service the nominal demand growth. When you destroy productive infrastructure at the rate which occurred during the Civil War (or in Zimbabwe in modern times) you have to severely cut spending to avoid inflation. But then that would have been impossible in the US in 1861 or so.<\/p>\n

By the onset of World War 1, the US was operating under a gold standard with fixed exchange rates and as such the Federal government was effectively financially constrained.<\/p>\n

The government could have issued bonds to the Federal Reserve (central bank) who would create a deposit account on behalf of the Treasury but the fear of inflation and what that would mean for the maintenance of the gold standard (it would fail) meant that the government had to “fund” its spending. In those times, the concept of the gold standard was held in the highest regard – a system that had to be preserved above anything else.<\/p>\n

So the government could either raise taxes or issue bonds. There were interesting debates at the time about the proportions which each would be used. The Treasury Secretary of the time William Gibbs McAdoo thought that a 50\/50 split would be best: (a) to recognise the argument that soldiers should not have to come home and pay higher taxes (to pay back the bonds); and (b) to ensure that taxes were not so high that the wealthy would start disputing the need to maintain the war effort.<\/p>\n

You can find a lot of information about the debates etc from the The American Libraries Archive<\/a>.<\/p>\n

\"liberty_bond_poster\"<\/a><\/p>\n

Anyway, in 1917 a new tax act was passed (War Revenue Act) and also the creation of the Liberty Bonds was announced. The following poster was part of the campaign that I describe below to engender public support for the Liberty Bonds.<\/p>\n

Prior to World War 1, Congress had to approve every tranche of US Government borrowing – including the volume of bonds, the coupon rate and the maturity.<\/p>\n

This was considered inflexible and time-consuming and so with the successful transition of the Second Liberty Bond Act in 1917, the U.S. Treasury was given a public debt limit.<\/p>\n

This meant it could borrow up to that amount with seeking the approval of Congress. All details of the bond issues also became the discretion of the Treasury.<\/p>\n

Unfortunately the on-line Congressional Record<\/a> which records all the debates in Congress only goes back to 1983 and as its is Xmas day I cannot visit the University Library here to access the records manually.<\/p>\n

You can also search the New York Times historical archive for editions of their newspaper in those times. Here is an example from the June 28, 1918 <\/a> about the bill. You can find many other pages from that era.<\/p>\n

From an historical perspective the rhetoric in the Source Book was interesting. On page 17 you read about the first issue of the liberty loan:<\/p>\n

\nThe loan was not merely as success, it was a triumph and a splendid demonstration of the patriotism and financial ability of the country … Secretary McAdoo mae especial efforts to make the loan a popular loan and to distribute the bonds among the individual citizens of the country as widely as possible. He made two speaking tours through the country arousing and informing people as to the needs of the situation, the value of the bonds, and the duty and wisdom of their investment in them.<\/p>\n

The campaign was marked by such cooperation and assistance from the people, the newspapers, National and State banks and trust companies, bond houses, and other corporations and business concerns and private firms and individuals, as well as fraternal, social, industrial, and other organisations, as to make it a great national movement …<\/p>\n

Never before was the business and the patriotism of the country so coordinated in a great national public service, and it was this that made the greatest loan in our history the most successful in our history.\n<\/p><\/blockquote>\n

And so on. The sentiment expressed in that time is totally different to what we read in the media and hear from commentary from business etc. Someone said to me once what will it take to solve unemployment (during the 1990s when it was very high and persistent in Australia following the severe 1991 recession). My reply was simple: we need another war.<\/p>\n

But I followed it up by noting we needed a war on unemployment to conjure up the solidarity that used to emerge when nations were under threat. I distinguish that solidarity from the partisan and divisive conflicts that have largely followed the Second World War (Vietnam to the unlawful invasion of Iraq).<\/p>\n

On Page 19 there is a discussion about whether the money raised is being “tied up” – you read that the “money” is being:<\/p>\n

\n… spent in this country and therefore immediately paid back to the people for labor and products of the United States. So far from being “tied up” this money is in effect never withdrawn from circulation.\n<\/p><\/blockquote>\n

This is almost getting us to the point of understanding that the public spending is underpinning jobs and wealth creation and because of the restrictive institutional arrangements of the day (gold standard) the only way the public could pursue such ventures was by cooperation from its citizens – to swap their liquidity for wealth and allow the governments to spend to create a broader concept of wealth.<\/p>\n

On Page 21 they discuss the security of the bond and the income flow – and we read that:<\/p>\n

\nThe wealth of the United States is back of the bonds issued by the Government. Since the present organization of the United States in 1790 no debts have ever been repudiated. The money borrowed has always been repaid …<\/p>\n

The interest on these bonds is a part of the Government’s expense. Should the power of our Government fail, not even cash would be of value, so high is our standing.\n<\/p><\/blockquote>\n

While it was clearly possible under a gold standard for the nation to go broke and have to default on outstanding public debt (as the UK did in 1931 when it was faced with a significant depletion of its gold reserves) the fact is that it was unlikely.<\/p>\n

The point being made is that the Government has the capacity if they keep the economy strong to repay its debt even under a gold standard. But clearly we need to understand that under a fiat monetary system there is no risk of insolvency – irrespective of the state of the economy.<\/p>\n

On Page 22 we read that that in Great Britain and elsewhere the government loans were seen in positive light by investors such that:<\/p>\n

\n… there sprang up a largel class of financiers and public economists who maintained that a great national debt was a great national blessing. While this opinion is not generally entertained, the idea of a Government being indebted to its own citizens in large sums of money is regarded as not at all analogous to indebtedness by an individual. The direct personal financial interest each citizen bondholder has in the Government is recognized as a valuable national force.\n<\/p><\/blockquote>\n

The source book then documents all the advantages to the bond holder in terms of risk-free wealth accumulation, risk-free income flows etc. So that is <\/p>\n

This interesting note<\/a> documents the features of the Act. This paper from the Congressional Research Service<\/a> is also interesting in understanding details of the Act etc in a modern setting.<\/p>\n

One discussion of later changes to the bill appears in The Public Debt Limit<\/em> written in 1954 by H.J. Cooke and M. Katzen (both working at the time at the New York Federal Reserve) and published in the The Journal of Finance, 9(3), 298-303. If you have access to JSTOR then you can get it via this LINK<\/a>. I am sorry but licensing rules prevent me from making the article available publicly here as a download.<\/p>\n

Cooke and Katzen trace the developments relating to the Second Liberty Bond Act 1917 and relate an interesting period immediately after WWII as the very large deficits that were required to prosecute the war effort (large is in relative historical terms) saw public debt levels rise significantly.<\/p>\n

In 1949, a new ceiling was requested from Congress and this was immediately approved by the House but was obstructed by the Senate. Cooke and Katzen say (p.302) that in the Senate:<\/p>\n

\n… the ceiling was viewed as an instrument for forcing economy on the executive branch of the government. During subsequent months, the statutory ceiling limited the scope for both new money borrowing and refunding transactions, but the Treasury by drawing down the level of its operating cash balance and by relying more heavily on private financing in certain programs held the public debt within the ceiling, although for a time by a small margin.\n<\/p><\/blockquote>\n

So politics politics.<\/p>\n

If you thought there was any logic to the rules then think again. From a modern monetary theory (MMT) perspective these rules and the restrictive accounting procedures that they lead too are just voluntary constraints that have been inherited from the gold standard days where exchange rates were fixed and governments were financially contrained.<\/p>\n

In the era of fiat currency systems, the rules have been perpetuated by the mainstream economics ideology to constrain government to give more latitiude for “market activity”. The lunacy of that stance is that the private sector actually does better when there is a strong fiscal involvement.<\/p>\n

Anyway, the public debt limit is one such voluntary constraint that could be easily legislated out of existence if the public truly understood how the monetary system operated and that time has moved on since 1971 when the convertible currency system collapsed.<\/p>\n

There are two components of total US public debt:<\/p>\n