\t\t\t\tAt times some document from the past is discovered that no-one much has read or paid any attention to but which offers fundamental insights into the options facing governments operating a monetary system based on a fiat currency. We have available now one such document which I will discuss in some detail. The essential insight can be summarised by the title of the blog – taxpayers do not fund anything. So when you hear commentators and politicians and the like use terms like “taxpayers’ funds are being mis-spent” etc, you can immediately conclude they do not understand how the monetary system functions. At that point, it is advisable to ignore what they have to say – given it is likely to be erroneous as a result of the initial false premises. The problem is that the public policy debate is largely based on these false premises. As a result, the policy positions that emerge are typically inferior and in many cases extremely damaging to the fortunes of the disadvantaged.
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\nTwo news stories over the weekend were interesting demonstrations of how ill-informed the policy debate is in the UK. And the debate in the UK is just a replica of the debate that is being conducted everywhere.<\/p>\n
Statements are continually being made by economists and others about important matters of public policy which are based on outrageously incorrect premises about how the monetary system operates and the opportunities that system provides to government policy choice.<\/p>\n
While it is heartening to see Goldman Sachs now being pursued in the courts (how long did that take?), my choice of target for prosecution would be my professional peers in economics who should be charged with torturing the minds of our youth with lies and ideology made to look like eternal truths.<\/p>\n
On Thursday (April 15, 2010), 77 economists wrote a letter to the UK Times<\/a> saying:<\/p>\n \nAs expected, a key election issue concerns how much to cut government expenditure in 2010\/11. The main opposition party now proposes to cut an extra \u00a36 billion in 2010\/11, on top of the measures already planned by the government. This cut is described as efficiency savings. But in macroeconomic terms it is just a cut by another name. It will lead directly to job losses and indirectly to further falls in spending through the standard multiplier process. At a time when recovery is delicate, it could even affect confidence to the degree that we are tipped back into recession – with much larger job consequences.<\/p>\n This is not the time for such a destabilising action. The recovery is still fragile. Firms and households are saving more to rebuild their balance sheets. This means that firms are investing less and households are spending less. Only when the recovery is well underway, will it be safe to have extra cuts in government expenditure.<\/p>\n The first step is to make sure that growth returns, and thus that tax receipts recover. Rash action now could imperil not only jobs but also the prospects for reducing the deficit.\n<\/p><\/blockquote>\n While many of the 77 economists are mainstreamers who have helped to perpetuate the NAIRU myth (for example, Lord Layard) over the years and contributed to supply-side policy developments (for example, the OECD Jobs Study) which have damaged the life prospects of millions by prolonging unemployment, others among the 77 are leading Post Keynesians. Again, it is another demonstration of the enemy within<\/a><\/p>\n Predictably, the letter was reported as providing a boost to the current UK government (Source<\/a>).<\/p>\n As you read the text you will probably find yourself nodding in agreement. But the underlying tenor of the letter is orthodox. They are expounding a deficit dove line that old-style Keynesians follow. While they argue that tax revenues “funds spending” they are not loathe to see governments use deficits sometimes. They worry about public debt issuance and totally fail to understand why it is issued. To tell them when deficits are sustainable they have nonsensical rules about stable public debt-GDP ratios. They think that these rules, if followed, will limit the size of the deficit – or so they think.<\/p>\n So “deficit doves” think deficits are fine as long as you wind them back over the cycle (and offset them with surpluses to average out to zero) and keep the public debt-GDP ratio in line with the ratio of the real interest rate to output growth. Torturous formulas are provided to students on all of this under the presumption that the government faces a financing constraint and as long as it is cautious things will be fine.<\/p>\n The point is that deficit-doves are essentially no different to the mainstream in perpetuating myths about the way the monetary system operates. The letter has all the deficit-dove hallmarks.<\/p>\n => Now is not the time to cut but later will be.<\/p>\n => Wait for recovery and then cut government spending.<\/p>\n => Wait for tax revenue to rise then cut.<\/p>\n => Cutting too early will increase the deficit which is a bad thing.<\/p>\n You will see all of those sentiments expressed in the letter. From the perspective of Modern Monetary Theory (MMT), none of the sentiments is of any applicability to a fiat currency-issuing government.<\/p>\n You might say that MMT would consider cutting too early to be a bad thing. That is certainly the case but the point is that it is the underlying sentiment that is misplaced and inapplicable. Cutting too early but having to cut later because you have to balance over the cycle is the erroneous sentiment that is rejected by MMT.<\/p>\n The overwhelming anxiety of the doves is that a government can live on the “wild side” (deficits) for a finite period only and then have to cut net spending and achieve surpluses during the other times. There is a constant level of anxiety underlying the positions offered by the doves.<\/p>\n They know that deficits help underpin demand and employment but are in fear of their inflationary consequences and also consider high public debt ratios to be dangerous and indicative of higher future tax rates. Doves think that governments are financially constrained.<\/p>\n MMT doesn’t offer an opinion about public deficits in this way. MMT considers them to be endogenously generated by non-government spending (and hence saving desires) and have to be whatever is necessary to underpin aggregate demand to achieve adequate employment growth. The goal is not a particular deficit position but other more important indicators of socio-economic well-being – for example, full employment.<\/p>\n Whether the budget deficit required to achieve full employment is 1 per cent of GDP or 10 per cent of GDP is immaterial to MMT. The differing scales just signal differences in non-government spending behaviour.<\/p>\n But a deficit-dove clearly sees a limit on the size of the deficit relative to the economy and current proportions are seen as needing attention. MMT also sees a limit on the deficit to GDP ratio – 100 per cent!<\/p>\n So while these 77 economists are trying to appear reasonable they miss the boat as badly as the more extreme mainstream economists.<\/p>\n Another glaring example of how economists get it wrong is found in the recent report<\/a> from the UK-based Institute of Fiscal Studies, which was reported in the Guardian on April 18, 2010 as saying Chancellor Brown left public finances “ill-prepared for the crunch”<\/a>. I plan to write a separate blog about the logic contained in this report.<\/p>\n The Guardian was content to just pass on the myths contained in the Report to its readers. So we read that:<\/p>\n \nIFS says Gordon Brown as Chancellor fell short of efforts by other industrialised nations to cut government debt … Gordon Brown put Britain’s public finances in a better shape in the run-up to the credit crunch than the Tories managed prior to the recession of the early 1990s, but he fell short of efforts by other industrialised nations to cut government debt and left the UK in a weak position to handle the fallout from the financial crisis, according to the Institute of Fiscal Studies.\n<\/p><\/blockquote>\n The IFS is described by the Guardian as a thinktank (although not much thinking of substance seems to go on there given the poverty of reasoning contained in the Report) admitted evidence from the Office for National Statistics showed that “public services have improved considerably over the period from 1997 to 2007 with measured outputs suggesting a one third increase in the quantity and quality of public services” as a result of deficit spending.<\/p>\n But their main emphasis is that the “high debt levels going into crisis meant the UK would have one of the weakest fiscal positions in 2010 after a deterioration in public finances only exceeded by Ireland and Iceland over the past three years”.<\/p>\n The IFS said that:<\/p>\n \nMost OECD governments did more to reduce their structural deficit during the period from 1997 to 2007 than Labour did. This fiscal position formed the backdrop to the financial crisis …\n<\/p><\/blockquote>\n To which I would add the sentences: However most OECD governments in slashing their deficits in a headlong, obsessive pursuit of surpluses also maintained higher unemployment rates and lower levels (quantity and quality) of public service delivery as a result. The UK government achieved far better outcomes as a consequence of their fiscal strategy in terms of indicators that matter (employment, etc) than the governments which were intent on abandoning their fiscal responsibility.<\/p>\n But the main point that you should take away from this is the nonsensical notion that past fiscal stances can in some way inhibit or constrain the capacity of a currency-issuing government to implement whatever fiscal policy choices they deem fit now. That belief is a myth and underpins much of the deficit-dove and mainstream thinking.<\/p>\n To be clear: a government which runs a surplus or deficit budget position last year (or for longer) is in a no better or worse position to run a deficit now should it deem that necessary.<\/p>\n For a start, the endogeneity of the fiscal position (driven by the automatic stabilisers) promotes swings in the balance as private spending fluctuates. This provides some counter-stabilising aggregate demand flows. But, in addition to those flows, a currency-issuing government can choose whatever level of discretionary net spending that they want.<\/p>\n Running surpluses in the past does not provide the government with any extra capacity to spend. In the same way, running large deficits in the past does not reduce the capacity of the government to spend and maintain those large deficits. Whatever large means anyway!<\/p>\n The UK government had exactly the same capacity to meet the economic crisis head-on with a properly-scaled fiscal intervention as any other sovereign currency-issuing government. That is, they all had an unlimited financial<\/strong> capacity.<\/p>\n The limitations on fiscal policy are all real. The government can only purchase what real goods and services are available for sale. Further, when there is strong private demand for these resources, the government’s bid can drive prices up.<\/p>\n But with nations all around the globe facing a depression, the government was unlikely to be competing for resources with non-government demand.<\/p>\n Taxes for revenue are obsolete<\/strong><\/p>\n As noted in the introduction, sometimes a document emerges that categorically exposes all these myths that economists perpetuate. Unfortunately, these documents get very little attention when they were originally published and then lie buried somewhere as the mainstream economists continue with business as usual.<\/p>\n In the last year of World War II, the then Chairman of the Federal Reserve Bank of New York, one Beardsley Ruml<\/a> addressed the American Bar Association.<\/p>\n You can access Guide to the Beardsley Ruml Papers 1917-1960<\/a> at the University of Chicago Library.<\/p>\n Historical records suggest the speech was a non-event and “attracted then less attention than it deserved”. In January 1946, the speech was published in the periodical American Affairs<\/em> and you can see the full text HERE<\/a>.<\/p>\n The title of the speech (and article) was Taxes for revenue are obsolete<\/strong> and I bolded this to make sure it resonated in your consciousness for a little time. Read it again – taxes for revenue are obsolete.<\/p>\n The Editor of American Affairs at the time wrote that Ruml’s:<\/p>\n \n… thesis is that given (1) control of a central banking system and (2) an inconvertible currency, a sovereign national government is finally free of money worries and need no longer levy taxes for the purpose of providing itself with revenue. All taxation, therefore, should be regarded from the point of view of social and economic consequences. The paragraph that embodies this idea will be found italicized in the text. Mr. Ruml does not say precisely how in that case the government would pay its own bills. One may assume that it would either shave its expenses out of the proceeds of taxes levied for social and economic ends or print the money it needs. The point may be academic. The latter end of his paper is devoted to an argument against taxing corporation profits.\n<\/p><\/blockquote>\n Ruml was writing at the time after the gold standard had broken down and before the Bretton Woods agreement which re-restablished currency convertibility and fixed exchange rates. Ruml, himself, was a major player at the BW conference.<\/p>\n But in 1945, the US was a sovereign currency-issuing nation as it is today! The intervening years saw world governments voluntarily cede this sovereignty to the fixed exchange rate system outlined in the Bretton Wood agreement which collapsed, finally, in 1971.<\/p>\n The main political intent of Ruml’s speech was to make a case that taxation is bad for business which is certainly not a central MMT perspective. But Ruml makes his case by arguing that if a government doesn’t need to tax to spend and when it taxes it hurts business then why would the government levy taxes.<\/p>\n So there are several propositions that are linked but separable.<\/p>\n This is how Ruml started to make his case:<\/p>\n \nThe superior position of public government over private business is nowhere more clearly evident than in government’s power to tax business. Business gets its many rule-making powers from public government. Public government sets the limits to the exercise of these rule-making powers of business, and protects the freedom of business operations within this area of authority. Taxation is one of the limitations placed by government on the power of business to do what it pleases.<\/p>\n There is nothing reprehensible about this procedure. The business that is taxed is not a creature of flesh and blood, it is not a citizen. It has no voice in how it shall be governed — nor should it. The issues in the taxation of business are not moral issues, but are questions of practical effect: What will get the best results? How should business be taxed so that business will make its greatest contribution to the common good?<\/p>\n It is sometimes instructive when faced with alternatives to ask the underlying question. If we are to understand the problems involved in the taxation of business, we must first ask: “Why does the government need to tax at all?” This seems to be a simple question, but, as is the case with simple questions, the obvious answer is likely to be a superficial one. The obvious answer is, of course, that taxes provide the revenue which the government needs in order to pay its bills.\n<\/p><\/blockquote>\n First, you understand that taxation is a way that government imposes limits on the non-government sector. Ruml is specifically interested in the busines sector but the argument generalises to all non-government entities.<\/p>\n Second, you also glean from the text that the question that needs to be asked in relation to some policy choice that imposes limitations on the non-government sector – is what “will make its greatest contribution to the common good”? In MMT we talk about advancing public purpose as the fundamental goal that should inform public policy choices. The correspondence between this concept and common good is close.<\/p>\n Third, are these limitations necessary? “Why does the government need to tax at all?” The superficial answer presented is the underlying claim of mainstream (and intuitive) thinking with regard to the purpose of taxation. But like all superfical appearances they are bound to be wrong. The point is that taxes do not<\/strong> “provide the revenue which the government needs in order to pay its bills”.<\/p>\n Ruml then continued to outline how governments could historically spend more than they received in tax revenue by borrowing. He says that borrowing “is an alternative which governments use to supplement the revenues from taxation in order to obtain the necessary means for the payment of their bills.” But:<\/p>\n \n… if a government persisted in borrowing heavily to cover its expenditures, interest rates would get higher and higher, and greater and greater inducements would have to be offered by the government to the lenders. These governments finally found that the only way they could maintain both their sovereign independence and their solvency was to tax heavily enough to meet a substantial part of their financial needs, and to be prepared —if placed under undue pressure — to tax to meet them all.\n<\/p><\/blockquote>\n So at this stage you will be thinking what is Bill quoting this guy for – all this sounds very mainstream – crowding out; increasing debt forcing taxes up in the future and the rest of it.<\/p>\n But then you will see what is going on by the next passage:<\/p>\n \nThe necessity for a government to tax in order to maintain both its independence and its solvency is true for state and local governments, but it is not true for a national government.\n<\/p><\/blockquote>\n And the penny drops! State and local governments are similar to a household in the sense they face financial constraints on their spending. They have to raise funds before they can spend. Sure enough, state and local governments have a taxing power that households do not possess. But this is a matter of degree not form.<\/p>\n But a national government is unique in a fiat currency monetary system. Ruml considers two developments to that point (in the last 25 years) had “substantially altered the position of the national state with respect to the financing of its current requirements”.<\/p>\n \nFinal freedom from the domestic money market exists for every sovereign national state where there exists an institution which functions in the manner of a modern central bank, and whose currency is not convertible into gold or into some other commodity.<\/p>\n The United States is a national state which has a central banking system, the Federal Reserve System, and whose currency, for domestic purposes, is not convertible into any commodity. It follows that our Federal Government has final freedom from the money market in meeting its financial requirements. Accordingly, the inevitable social and economic consequences of any and all taxes have now become the prime consideration in the imposition of taxes. In general, it may be said that since all taxes have consequences of a social and economic character, the government should look to these consequences in formulating its tax policy. All federal taxes must meet the test of public policy and practical effect. The public purpose which is served should never be obscured in a tax program under the mask of raising revenue.\n<\/p><\/blockquote>\n So that statement is as clear as you will get and totally consistent with the fundamental insights offered by MMT. When there is no currency convertibility and exchange rates are flexible, then the central bank has total liberty to create financial assets (money) and the federal government is totally free from any financing constraints.<\/p>\n Please read my blog – Who is in charge?<\/a> – for more discussion on this point.<\/p>\n So this raises the question: if the government is not financially constrained then why does it impose taxes (especially if they are bad for growth etc)?<\/p>\n Ruml offers four insights into the purpose of taxation:<\/p>\n \nFederal taxes can be made to serve four principal purposes of a social and economic character. These purposes are:<\/p>\n 1. As an instrument of fiscal policy to help stabilize the purchasing power of the dollar;<\/p>\n 2. To express public policy in the distribution of wealth and of income, as in the case of the progressive income and estate taxes;<\/p>\n 3. To express public policy in subsidizing or in penalizing various industries and economic groups;<\/p>\n 4. To isolate and assess directly the costs of certain national benefits, such as highways and social security.\n<\/p><\/blockquote>\n Purpose 1 is about inflation control. A fundamental principle of MMT is that the imposition of taxes allows the government to manage the state of aggregate demand. So if nominal demand is outpacing the capacity of the economy to respond in real output terms then tax rises withdraw non-government purchasing power from the expenditure system and reduce the multiplier.<\/p>\n Ruml says that “(i)f federal taxes are insufficient or of the wrong kind, the purchasing power in the hands of the public is likely to be greater than the output of goods and services with which this purchasing demand can be satisfied. If the demand becomes too great, the result will be a rise in prices, and there will be no proportionate increase in the quantity of things for sale. This will mean … inflation. On the other hand, if federal taxes are too heavy or are of the wrong kind, effective purchasing power in the hands of the public will be insufficient to take from the producers of goods and services all the things these producers would like to make. This will mean widespread unemployment.”<\/p>\n Purpose 2 is about redistribution and the point is obvious. Purpose 3 is obvious.<\/p>\n Purpose 4 is awkwardly expressed because it invokes the superficial logic. But it is actually about hypothecated spending. The argument is that politically contentious spending should be transparent. Taxes are, in fact, “demand drains” and so reduce the capacity of the non-government sector to spend. In this sense, the transparency allows the non-government sector to see exactly what “demand injection”(say highway spending) is replacing the command on resources that households and firms would have had in the absence of the taxes. It has nothing to do with the taxes funding anything. Just a $-for-$ matching to help expose the opportunity cost.<\/p>\n Please read my blog – Functional finance and modern monetary theory<\/a> – for more discussion on these point.<\/p>\n Ruml then outlines the notion of public purpose:<\/p>\n \nIn the recent past, we have used our federal tax program consciously for each of these purposes. In serving these purposes, the tax program is a means to an end. The purposes themselves are matters of basic national policy which should be established, in the first instance, independently of any national tax program.\n<\/p><\/blockquote>\n Again, nothing could be clearer. National policy priorities are the central question. Then the taxation serves as part of an overall functional finance policy package to advance these goals as best as the government can. For Ruml “(t)he tax program should be devised as an instrument, and it should be judged by how well it serves its purpose”.<\/p>\n Conclusion<\/strong><\/p>\n This speech as delivered in 1945 as the US economy was in transition between the gold standard and the Bretton Woods system. In other words, the US government has much the same currency sovereignty that it enjoys today.<\/p>\n The insights provided by Ruml accord with the essential principles outlined by MMT. <\/p>\n They are totally at odds with the intuitive logic applied by the person in the street and the lies expounded in mainstream macroeconomics textbooks.<\/p>\n Taxpayers do not fund anything. They just lose or gain purchasing powere as the national government manipulates the policy parameters in search of public purpose. The fact the government doesn’t achieve desirable outcomes (through incompetence etc) is not the point.<\/p>\n The Fiscal Sustainability Teach-In and Counter-Conference Update<\/strong><\/p>\n I mentioned that a group has formed in the US to promote MMT and the first event is a conference on fiscal sustainability on April 28, 2010 in Washington DC to rival the sham conference exploring the same topic which is being sponsored by the Peter Peterson organisation.<\/p>\n You can see Update<\/a> with program etc.<\/p>\n