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Budget deficits do not cause higher interest rates

I have always been antagonistic to the mainstream economic theory. I came into economics from mathematics and the mainstream neoclassical lectures were so mindless (using very simple mathematical models poorly) that I had plenty of time to read other literature which took me far and wide into all sorts of interesting areas (anthropology, sociology, philosophy, history, politics, radical political economy etc). I also realised that the development of very high level skills in empirical research (econometrics and statistics) was essential for a young radical economist. Most radicals fail in this regard and hide their inability to engage in technical debates with the mainstream by claiming that formalism is flawed. It might be but to successfully take on the mainstream you have to be able to cut through all their technical nonsense that they use as authority to support their ridiculous policy conclusions. That is why I studied econometrics and use it in my own work. It was strange being a graduate student. The left called be a technocrat (a put-down in their circles) while the right called me a pop-sociologist (a put down in their circles). I just knew I was on the right track when I had all the defenders of unsupportable positions off-side. But an appreciation of the empirical side of debates is very important if a credible challenge to the dominant paradigm is to be made. That has motivated me in my career.

The Australian Treasury released a paper last week – Reconsidering the Link between Fiscal Policy and Interest Rates in Australia – which “examines the empirical relationship between government debt and the real interest margin between Australian and US 10 year government bond yields”.

In English, that means they were seeking to examine whether increasing budget deficits pushed up interest rates which is one of the conservative claims to butress their case against the use of fiscal policy as a counter-stabilisation tool (that is, to correct aggregate demand failures).

An often-cited paper outlining the ways in which budget deficits allegedly push up interest rates is – Government Debt – by Elmendorf and Mankiw (1998 – subsequently published in a book in 1999). This paper was somewhat influential in perpetuating the mainstream myths about government debt and interest rates. Clearly Mankiw still believes in the logic given it occupies a central part of his macroeconomics textbook.

Elmendorf at the time was on the US Federal Reserve Board. It is a pity for the American people that he is now the director of the US Congressional Budget Office.

If you read the paper (and frankly it will waste your precious time to do so), you will note that the paper’s motivation was the rise in public debt between 1980 and 1997. The same sort of rhetoric was being used then as now – spiralling (out of control) public debt. Did the sky fall in then? Answer: No! The rise in the debt presented no problems – interest rates didn’t balloon and inflation didn’t become accelerate out of control.

Elmendorf and Mankiw state that the “conventional” view, which is “held by most economists and almost all policymakers”, considers that:

… the issuance of government debt stimulates aggregate demand and economic growth in the short run but crowds out capital and reduces national income in the long run.

Their depiction of the alternative to the convention view is – Ricardian equivalence – which alleges that:

… the choice between debt and tax finance of government expenditure is irrelevant … [because] … a budget deficit today … [requires] … higher taxes in the future. Thus, the issuing of government debt to finance a tax cut … [or any net spending increase] … represents not a reduction in the tax burden but merely a postponement of it. If consumers are sufficiently forward looking, they will look ahead to the future taxes implied by government debt. Understanding that their total tax burden is unchanged, they will not respond to the tax cut by increasing consumption. Instead, they will save the entire tax cut to meet the upcoming tax liability; as a result, the decrease in public saving (the budget deficit) will coincide with an increase in private saving of precisely the same size. National saving will stay the same, as will all other macroeconomic variables.

I have dealt with this view extensively in a number of blogs – Pushing the fantasy barrowEven the most simple facts contradict the neo-liberal argumentsDeficits should be cut in a recession and We are sorry – for more detailed discussion on the folly of Ricardian equivalence

Ignoring the fact that the description of a government raising taxes to pay back a deficit is nonsensical when applied to a fiat currency issuing government, the Ricardian Equivalence models rest of several key and extreme assumptions about behaviour and knowledge. Should any of these assumptions fail to hold (at any point in time), then the predictions of the models are meaningless.

The other point is that the models have failed badly to predict or explain key policy changes in the past. That is no surprise given the assumptions they make about human behaviour.

There are no Ricardian economies. It was always an intellectual ploy without any credibility to bolster the anti-government case that was being fought then (late 1970s, early 1980s) just as hard as it is being fought now. Stacks of doctoral theses were written about it – justifying it, etc. None should have passed because they had no knowledge value at all. PhDs are meant to be awarded for advances in knowledge.

Everytime you read an article or chapter or whatever that invokes Ricardian Equivalence to justify its thesis – stop reading immediately and finds something better to do.

In terms of the “conventional” analysis, Elmendorf and Mankiw state that in the short-run an increase in the budget deficit (say via a tax cut with spending constant):

… raises households’ current disposable income and, perhaps, their lifetime wealth as well. Conventional analysis presumes that the increases in income and wealth boost household spending on consumption goods and, thus, the aggregate demand for goods and services … This Keynesian analysis provides a common justification for the policy of cutting taxes or increasing government spending (and thereby running budget deficits) when the economy is faced with a possible recession.

So far so good. This account is not at odds with Modern Monetary Theory (MMT) except that the decision to run budget deficits does not turn on the state of the business cycle. It depends on the state of non-government spending and saving decisions. The aim of the budget deficit is to ensure aggregate demand gaps do not occur which would undermine output and employment growth.

The prior choice that the government has to make is the mix of public and private activity at full capacity. How much public output is required to advance the socio-economic mandate that the political process has bestowed on the government? That is the question that has to be considered initially.

The answer sets the full-employment size of government. Then the government has to manage fluctuations in that size when private spending fluctuates. If private spending increases above this implied “size” then the government would tax the private purchasing power away. If the non-government spending fell below the necessary level (or rate of growth) then the budget deficit has to rise temporarily to fill the gap and maintain growth.

This is the way in which counter-stabilisation policy is conducted. But it may be appropriate (and typically will be) within this process for the government to continuously run budget deficits to ensure the non-government is continuously net saving in the currency of issue. So deficits are not just about bailing out recessions.

But then the wheels fall off in the Elmendorf and Mankiw paper. They say:

Conventional analysis also posits, however, that the economy is classical in the long run. The sticky wages, sticky prices, or temporary misperceptions that make aggregate demand matter in the short run are less important in the long run. As a result, fiscal policy affects national income only by changing the supply of the factors of production. The mechanism through which this occurs is our next topic.

This is the crucial point. The analysis belongs to the class of models that consider that business cycle fluctuations occur because the supplies of input vary as their owners (including workers) make optimising adjustments to the quantities they are prepared to supply. These fluctuations occur around the “natural rate of output” or “natural rate of unemployment” (the two concepts are linked via technology).

Only technology and population matter in the long-run and government spending cannot alter short-run variations in output. Ultimately, the economy sits on its long-run growth path which is invariant to government policy.

Elmendorf and Mankiw us the standard national accounting identities to make their case. So they say that national income (Y) is from the perspective of the households either consumed (C), saved (S) or taxed (T):

Y = C + S + T .

National income (output) is equal to aggregate demand (expenditure):

Y = C + I + G + NX

where I is domestic investment, G is government purchases of goods and services, and NX is net exports of goods and services.

Combining these accounting identities and re-arranging them, provides us with the familiar sectoral balances:

S + (T-G) = I + NX .

Which says that private saving (S) plus the government surplus (T-G) equals investment plus net exports.

Elmendorf and Mankiw call (T-G) public saving but that is an erroneous description of the monetary implications of a sovereign government running a budget surplus.

When individuals (households) save they postpone current consumption because they want to have higher future consumption. Saving is a time machine for non-government entities to allow them to transfer consumption across time. The obvious motivation is that they face a budget constraint – as users of the currency – and have to forgoe consumption now if they want to save.

For the monopoly issuer of the currency – the sovereign government – there is no such financial constraint on spending. It does not have to forgoe spending now to spend in the future. It can always spend what it desires at any point in time irrespective of what it did last period or any previous periods.

Further, when the government runs a budget surplus the purchasing power it extracts from the non-government sector doesn’t go anywhere – it is not stored in any account to use for later purposes. Just as a budget deficit (excess of spending over tax revenue) creates net financial assets (in the currency of issue) a budget surplus destroys net financial assets.

There is no store of purchasing power when the government runs a surplus nor does it make any sense for a government to think in those terms. It can always spend what it likes.

So it is nonsensical to characterise a budget surplus as being “saving”. It is more correctly described as the destruction of non-government purchasing power the non-government net financial assets.

But the sectoral flow equation is sound as written.

Elmendorf and Mankiw then correctly point out that:

… a nation’s current account balance must equal the negative of its capital account balance.

So net exports equals net foreign investment, or NFI, “which is investment by domestic residents in other countries less domestic investment undertaken by foreign residents”:


This just means that the “international flows of goods and services must be matched by international flows of funds”. This equality is however subject to interpretation and the mainstream paradigm constructs it as meaning that nations with current account deficits (CAD) are living beyond their means and are being bailed out by foreign savings.

From an MMT perspective, a CAD can only occur if the foreign sector desires to accumulate financial (or other) assets denominated in the currency of issue of the country with the CAD.

This desire leads the foreign country (whichever it is) to deprive their own citizens of the use of their own resources (goods and services) and net ship them to the country that has the CAD, which, in turn, enjoys a net benefit (imports greater than exports). A CAD means that real benefits (imports) exceed real costs (exports) for the nation in question.

So the CAD signifies the willingness of the citizens to “finance” the local currency saving desires of the foreign sector. MMT thus turns the mainstream logic (foreigners finance our CAD) on its head in recognition of the true nature of exports and imports.

Subsequently, a CAD will persist (expand and contract) as long as the foreign sector desires to accumulate local currency-denominated assets. When they lose that desire, the CAD gets squeezed down to zero. This might be painful to a nation that has grown accustomed to enjoying the excess of imports over exports. It might also happen relatively quickly. But while the situation lasts the importing nation is getting real benefits and should enjoy them.

Please read my blog – Modern monetary theory in an open economy – for more discussion on this point.

The standard procedure is then to substitute the NX = NFI into the previous sectoral balance expression S + (T-G) = I + NX to get:

S + (T-G) = I + NFI

which they say:

… shows national saving as the sum of private and public saving, and the right side shows the uses of these saved funds for investment at home and abroad. This identity can be viewed as describing the two sides in the market for loanable funds.

Note the comments above about the erroneous contruction of public saving.

MMT constructs this version of the sectoral balances as saying for national income to be unchanged the leakages from the spending system [left-hand side => S + (T-G)] have to be equal to the injections [right-hand side => I + NFI]. If the actual leakages in any period exceed the injections then income will fall to bring the relationship back into equality. I could go on about this at length but haven’t the time today.

But more importantly, once Elmendorf and Mankiw introduce the loanable funds model to explain why budget deficits drive up interest rates you know they are entering the land of myths.

They motivate their discussion of the previous identity in this way:

Now suppose that the government holds spending constant and reduces tax revenue, thereby creating a budget deficit and decreasing public saving. This identity may continue to be satisfied in several complementary ways: Private saving may rise, domestic investment may decline, and net foreign investment may decline.

They claim that “private saving rises by less than public saving falls” which means that “total investment–at home and abroad–must decline as well”.

The fall in investment reduces the capital stock (reducing income and output) and increasing the interest rate. Why? Answer: according to the marginal productivity theory (MPT) the lower capital stock means the smaller stock of capital is now more productive and so the rate of return rises which forces all interest rates up as well as pushing real wages down.

Further, because they claim there is a “decline in net foreign investment” this requires a “decline in net exports” and a rising budget current account deficit – and so they think they substantiate the “twin deficits” argument. Please read my blog – Twin deficits – another mainstream myth – for more discussion on this point.

None of this is remotely what happens.

In terms of the above model [S + (T-G) = I + NFI], MMT suggests that as (T-G) falls (net public spending rises), national income rises which also stimulates saving (S). Further, it may increase imports which may reduce NX but in that situation the exchange rate pressure will increase international competitiveness and stimulate exports (X) and attract foreign investors (NFI).

The rising activity will also stimulate investment (I) as firms sense improved opportunities to realise profits by expanding capacity (this is known as the accelerator effect in the literature). With the central bank in charge of interest rates, the budget deficit “crowds-in” private spending.

So where do the mainstream economists go wrong? At the heart of this conception is the theory of loanable funds, which is a aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking. The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.

In Mankiw’s macroeconomics textbook, which is representative, we are taken back in time, to the theories that were prevalent before being destroyed by the intellectual advances provided in Keynes’ General Theory.

Mankiw assumes that it is reasonable to represent the financial system as the “market for loanable funds” where “all savers go to this market to deposit their savings, and all borrowers go to this market to get their loans. In this market, there is one interest rate, which is both the return to saving and the cost of borrowing.”

This is back in the pre-Keynesian world of the loanable funds doctrine (first developed by Wicksell).

This doctrine was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times. If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving.

So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded. The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.

The following diagram shows the market for loanable funds. The current real interest rate that balances supply (saving) and demand (investment) is 5 per cent (the equilibrium rate). The supply of funds comes from those people who have some extra income they want to save and lend out. The demand for funds comes from households and firms who wish to borrow to invest (houses, factories, equipment etc). The interest rate is the price of the loan and the return on savings and thus the supply and demand curves (lines) take the shape they do.

Note that the entire analysis is in real terms with the real interest rate equal to the nominal rate minus the inflation rate. This is because inflation “erodes the value of money” which has different consequences for savers and investors.

Mankiw claims that this “market works much like other markets in the economy” and thus argues that (p. 551):

The adjustment of the interest rate to the equilibrium occurs for the usual reasons. If the interest rate were lower than the equilibrium level, the quantity of loanable funds supplied would be less than the quantity of loanable funds demanded. The resulting shortage … would encourage lenders to raise the interest rate they charge.

The converse then follows if the interest rate is above the equilibrium.


Mankiw also says that the “supply of loanable funds comes from national saving including both private saving and public saving.” Think about that for a moment. Clearly private saving is stockpiled in financial assets somewhere in the system – maybe it remains in bank deposits maybe not. But it can be drawn down at some future point for consumption purposes.

Mankiw thinks that budget surpluses are akin to this. As noted above – budget surpluses are not even remotely like private saving. You should clearly understand by now that budget surpluses destroy liquidity in the non-government sector (by destroying net financial assets held by that sector). They squeeze the capacity of the non-government sector to spend and save. If there are no other behavioural changes in the economy to accompany the pursuit of budget surpluses, then as we will explain soon, income adjustments (as aggregate demand falls) wipe out non-government saving.

So this conception of a loanable funds market bears no relation to “any other market in the economy” despite the myths that Mankiw uses to brainwash the students who use the book and sit in the lectures.

Also reflect on the way the banking system operates. The idea that banks sit there waiting for savers and then once they have their savings as deposits they then lend to investors is not even remotely like the way the banking system works.

Please read the following blogs – Money multiplier and other mythsBuilding bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.

This framework is then used to analyse fiscal policy impacts and the alleged negative consquences of budget deficits – the so-called financial crowding out – is derived.

In relation to the diagram above, Mankiw asks: “which curve shifts when the budget deficit rises?”

Consider the next diagram, which is used to answer this question. The mainstream paradigm argue that the supply curve shifts to S2.

Why does that happen? The twisted logic is as follows: national saving is the source of loanable funds and is composed (allegedly) of the sum of private and public saving. A rising budget deficit reduces public saving and available national saving. The budget deficit doesn’t influence the demand for funds (allegedly) so that line remains unchanged.

The claimed impacts are: (a) “A budget deficit decreases the supply of loanable funds”; (b) “… which raises the interest rate”; (c) “… and reduces the equilibrium quantity of loanable funds”.

Mankiw says that:

The fall in investment because of the government borrowing is called crowding out …That is, when the government borrows to finance its budget deficit, it crowds out private borrowers who are trying to finance investment. Thus, the most basic lesson about budget deficits … When the government reduces national saving by running a budget deficit, the interest rate rises, and investment falls. Because investment is important for long-run economic growth, government budget deficits reduce the economy’s growth rate.


The analysis relies on layers of myths which have permeated the public space to become almost “self-evident truths”. Obviously, national governments are not revenue-constrained so their borrowing is for other reasons – we have discussed this at length. This trilogy of blogs will help you understand this if you are new to my blog – Deficit spending 101 – Part 1 | Deficit spending 101 – Part 2 | Deficit spending 101 – Part 3.

But governments do borrow – for stupid ideological reasons and to facilitate central bank operations – so doesn’t this increase the claim on saving and reduce the “loanable funds” available for investors? Does the competition for saving push up the interest rates?

Answer: No and no!

But we need to be careful. MMT does not claim that central bank interest rate hikes are not possible. It is possible that a poorly managed central bank will interpret a rising budget deficit as being inflationary and push up interest rates. There is also the possibility that rising interest rates reduce aggregate demand via the balance between expectations of future returns on investments and the cost of implementing the projects being changed by the rising interest rates.

MMT proposes that the demand impact of interest rate rises are unclear and may not even be negative depending on rather complex distributional factors. Remember that rising interest rates represent both a cost and a benefit depending on which side of the equation you are on. Interest rate changes also influence aggregate demand – if at all – in an indirect fashion whereas government spending injects spending immediately into the economy.

But having said that, the Classical claims about crowding out are not based on any of these mechanisms. In fact, they assume that savings are finite and the government spending is financially constrained which means it has to seek “funding” in order to progress their fiscal plans. The result competition for the “finite” saving pool drives interest rates up and damages private spending. This is what is taught under the heading “financial crowding out”.

A related theory which is taught under the banner of IS-LM theory (in macroeconomic textbooks) assumes that the central bank can exogenously set the money supply. Then the rising income from the deficit spending pushes up money demand and this squeezes interest rates up to clear the money market. This is the Bastard Keynesian approach to financial crowding out. Please read my blog – Those bad Keynesians are to blame – for more discussion on this point.

Neither theory is remotely correct and is not related to the fact that central banks push up interest rates up because they believe they should be fighting inflation and interest rate rises stifle aggregate demand.

So the Elmendorf and Mankiw claim is summarised like this (from the Australian Treasury paper):

… a budget deficit reduces national saving, which implies a shortage of funds to finance investment. This would place upward pressure on interest rates as firms compete to finance their investments from the existing pool of domestic saving.

But from a macroeconomic flow of funds perspective, the funds (net financial assets in the form of reserves) that are the source of the capacity to purchase the public debt in the first place come from net government spending. Its what astute financial market players call “a wash”. The funds used to buy the government bonds come from the government!

There is also no finite pool of saving that is competed for. Loans create deposits so any credit-worthy customer can typically get funds. Reserves to support these loans are added later – that is, loans are never constrained in an aggregate sense by a “lack of reserves”. The funds to buy government bonds come from government spending! There is just an exchange of bank reserves for bonds – no net change in financial assets involved. Saving grows with income.

But importantly, deficit spending generates income growth which generates higher saving. It is this way that MMT shows that deficit spending supports or “finances” private saving not the other way around.

The Australian Treasury paper also notes that “a budget deficit may not reduce the domestic capital stock as the adjustment can occur through higher capital inflows — which may not necessarily change interest rates”. Pretty basic really even without the extra MMT insights in the preceding paragraphs.

In discussing the conventional view, Elmendorf and Mankiw offer the parable of the debt fairy to compute the “crowding out of capital” effects? They ask us to:

Imagine that one night a debt fairy (a cousin of the celebrated tooth fairy) were to travel around the economy and replaced every government bond with a piece of capital of equivalent value. How different would the economy be the next morning when everyone woke up?

How cute! A debt fairy who can just alter the maximising decisions of the private sector overnight and force portfolio choices upon that same sector that presumably do not correspond with the profit-seeking circumstances that prevailed when the investors eschewed the decision to accumulate physical capital and invested in bonds instead.

The debt fairy in fact has no application to the modern monetary system. The

Had they invested in physical capital the public deficit would have been lower anyway and the debt-issued lower.

But even they have to admit that this construction is erroneous (you can read why if you are interested).

The Australian Treasury paper acknowledges that the state of mainstream theory is such that:

the theoretical ambiguities about the connection between debt and interest rates … [provide no robust conclusions].

That is, the mainstream theoretical literature is so dependent on extreme assumptions and total falsehoods about the way the real world monetary system operates that the major conclusions are without theoretical authority

Most of the results in the mainstream literature require extreme assumptions to derive the main conclusions. Even within the logic of their own flawed models if you relax one of these key assumptions the whole analytical edifice collapses and the conclusions are no longer supported by the theory.

Virtually none of the assumptions that underpin the key mainstream models relating to the conduct of government and the monetary system hold in the real world. This means that the mainstream macroeconomic conclusions cannot be typically based on the theoretical models. At that point they become ideological.

In terms of the New Keynesian models which drive the Elmendorf and Mankiw reasoning and now represent the “conventional” view of monetary systems, the claimed theoretical robustness of their models always give way to empirical fixes in response to anomalies.

This general ad hoc approach to empirical anomaly cripples the mainstream macroeconomic models and strains their credibility. When confronted with increasing empirical failures, the mainstream economists introduce these ad hoc amendments to the specifications to make them more realistic. I could provide countless examples which include studies of habit formation in consumption behaviour; contrived variations to investment behaviour such as time-to-build , capital adjustment costs or credit rationing.

Further, the New Keynesian authors (like Mankiw et al) appear unable to grasp is that these ad hoc additions, which aim to fill the gaping empirical cracks in their models, also compromise the underlying rigour provided by the assumptions of intertemporal optimisation and rational expectations. At least, they never admit to this and leave the unsuspecting (usually uncritical) reader thinking that the conclusions are valid.

Please read my blog – Mainstream macroeconomic fads – just a waste of time – for more discussion on this point.

Next time you hear a politician or some conservative start raving about crowding out ask them a few questions:

1. Why are you assuming the pool of domestic saving and/or foreign saving is finite?

2. Don’t banks lend to credit-worthy customers?

3. Where did the funds the government borrows come from?

4. Why have interest rates been around zero and long-term yields not much higher in Japan for two decades despite rising budget deficits?

See their eyes roll and enjoy the moment?

Australian Treasury Paper results

Anyway, the Australian Treasury Paper cites a number of empirical studies that “find” that rising deficits drive up interest rates. I know all of the papers cited well and each one is deeply flawed in both conception or empirical application. None of them hold water.

I won’t describe the econometric method the Paper employs but it is standard and the results are not biased one way or another by the choice of estimation technique. We could quibble about some technical matters but it would be “chess playing” rather than a constituting a substantive attack on the results.

The Australian Treasury Paper concludes that:

… in the long run, the real interest margin rises by around three basis points in response to a one percentage point of GDP increase in the stock of Australian general government net debt … In the short run, however, Australian fiscal variables do not have a statistically significant impact on the interest margin. Importantly, the results indicate that a number of US economic variables, namely inflation and the current account, exert the most powerful influence on the real interest margin.

So domestic budget deficits do not drive up interest rates. The long-run effect (a stylised econometric state!) is virtually zero. The short-run effect is zero!

Zero means nothing – no relationship – go away!

I posted the following graph in an earlier blog – Twin deficits – another mainstream myth – but it is worth repeating. It is based on Reserve Bank of Australia data and shows the relationship between the federal budget deficit and the overnight interest rate from 1977 to now. The different colours indicate the period before (blue) and after (green) the exchange rate was floated.

You will appreciate clearly – there is no relationship. This graph could be reproduced for the advanced world and you wouldn’t find a robust relationship. So that avenue for the TDH is missing.

The Australian Treasury Paper used advanced econometric analysis to find the same thing. Good on them but they could have just looked at this graph and reflected on the way the monetary system operates to reach the same conclusion. I am happy though that they have jobs and are free from the ravages of unemployment!

In his Melbourne Age article last week (September 18, 2010) – Treasury backflip on deficit link – economic correspondent Tim Colebatch describes the Australian Treasury Paper as providing:

… a stunning backflip from Treasury’s earlier views … [which] … challenges a large body of work by other economists that find a strong link between fiscal policy and interest rates.


Lets hope that within Australian macroeconomic policy circles, at least, this insight becomes the norm.

Also all you macroeconomics teachers and lecturers out there – toss out your Mankiw textbooks and start teaching your students something that is closer to the truth. Otherwise, you should resign.

That is enough for today!

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    This Post Has 139 Comments
    1. “What can I get if the government decides my tax liability is zero”

      A tax credit.

      The tax credit is your asset, good for paying taxes in the future.

      The government can’t decide on your tax liability for next year, until next year has come and gone.

      “I understand now. I still don’t take away anything useful from your point.”

      It was you that introduced the question.

      If you understand now, you are enlightened.

      Most would consider enlightenment to be psychically useful.

    2. Anon,

      You said:

      You have dealt with these points at huge and effective length in numerous blogs, but still my preference would be to see a heightened emphasis on their central role in the overall paradigm for the MMT message. My impression now is that more than enough emphasis is placed on an explanation of the working of the monetary system, including some semantic baggage that tends toward overkill and oversimplification. E.g. out of many: too much emphasis on “taxes going nowhere”, which in my view frankly is a trailer park interpretation of a very simple, very general but somewhat more elegant concept in finance, which is that income can always be applied toward the reduction of a net liability position. Conversely, more emphasis might be placed on thoroughly debunking the very dangerous “inflation is always and everywhere a monetary phenomenon”.

      This a public blog. Some of us might live in trailers!

      It’s appropriate to break the concepts down into simplistic terms (or analogies) for people without an economics background to understand. I think you are smart enough to understand what is meant when a layperson refers to concepts like “printing money” or “taxes disappearing down a black hole”. There was no real need to labour on the semantics and a legalistic bankers description of the monetary system. Nevertheless, you are knowledgeable and precise, so it was a good exercise for the smarter posters to hone their debating skills.

      After several reads, I think (??) I get your main points. they appear valid to me. In my view, ideas have to be explainable on a bumper sticker to get popular credence. May I hazard an attempt at simplification of your points?

      From a different perspective. A household budget can be considered unconstrained and a Government budget constrained. We should not take the broad assumption of household constraint and unconstrained Government budgets to dangerous extremes.

      MMT would garner greater support if more emphasis was placed on….. How to run an expansionary monetary policy AND manage inflation.

      I’m curious to know if I am getting the arguments, so I’d appreciate feedback. I have been hit and miss with my understanding so far :)

    3. Tom, it seems like you are saying:

      “All financial transactions are settled either in physical currency or bank reserves, except those that aren’t”.

      which would of course be tautologically correct, but consequently a much weaker statement.

      The semantic to-and-fro about “spending by crediting bank accounts” got me a bit lost, I must admit. It seems to me that both commercial banks and the government spend by “crediting bank accounts”, but that the difference lies in the consequences of the change in equity of the entity doing the spending, since, unlike commercial banks, the gov/CB can (I assume) operate with negative equity. Or am I missing something?

    4. anon said:

      “A tax credit.”

      Let’s say I accept your strange definition of liability. What is its utility? Does it allow us to predict anything interesting? What?

    5. “From a different perspective. A household budget can be considered unconstrained and a Government budget constrained.”

      What is the utility of this perspective? There must be utility in this perspective for it to have any value because another perspective (the MMT perspective) has a great deal of utility.

    6. Andrew,

      Thanks for your question.

      As Bill said, there are some gymnastics going on here, and I am not innocent of that charge. The points are rather subtle in the context of MMT.

      The essence of the unconstrained/constrained differentiation in MMT is that of currency issuer versus currency user. Simplified, the unconstrained issuer can practise the causality/order of spending and then issuing currency to pay for the spending. The issuer issues bonds today in order to drain the money that otherwise would be left in the system by spending. A feasible alternative financial architecture would be not to issue bonds at all. By contrast, the constrained user must go and get the money, by bank borrowing or issuing bonds, for example. The constrained user doesn’t have the freedom of being an issuer.

      In this context, MMT views the universe of currency issuers as comprising fiat currency issuing governments. That’s fine as far as it goes.

      I’ve raised several points.

      The first is that the currency issuing function is at its core banking function. In the case of a government, it relies on its central bank to do the first order issuing via bank reserves. MMT explores the possibility that central bank independence could be eliminated, with that function essentially combined with the government treasury. The balance sheet of the combined entity looks like the liability side of the modern central bank, but with additional liabilities corresponding to the cumulative government deficit. The bottom line either way is that currency issuance is a banking function, and the government requires a banking function in order to be a currency issuer.

      My second point is that banking more broadly includes commercial banks, and what they do for the other sectors. They provide credit. E.g. a household that takes out a new loan to spend on consumer credits puts in motion a banking function that results in new bank deposits. That functionality shares some similarity to the central bank currency issuance function.

      To see this more clearly, suppose the banking system consisted of just a single central bank and no commercial banks. Then the non government sector would borrow from that single bank and create money in the same way that the government does.

      Moreover, there would be no bank reserves in such a mono-bank system. The only unique purpose of bank reserves is to create an interbank settlement facility in a competitive multi-bank system. At its root, the essence of currency issuance shouldn’t really depend on a multi-bank reserve requirement. It is interesting that MMT relies heavily on reserve based explanations for many of its expositions of how the monetary system works. Is there a case for a different approach?

      So my observation is that households and others are effectively currency issuers when they borrow to spend. My suggestion is that a different differentiation might be possible in explaining MMT – instead of currency issuers and users, the idea of issuance limits. The issuance limit for non government is based on the usual credit risk analysis. The question then becomes, what is the issuance limit for government? MMT responds that there isn’t one – that’s the nature of not being constrained. And in a way, it’s easy to see this.

      Yet there is a limit prescribed by MMT itself, and that is the notion of real constraints on government spending. So at some level, the real constraint for government parallels the credit risk limit for non government. That comparison would be my starting logic for MMT, rather than issuer/user. Issuer/user is a powerful differentiation, but it could be tweaked along the lines I’ve suggested.

      In terms of some of the other issues, MMT applies strenuous effort to demystify popular misperception, using such phrases as “spending by crediting bank accounts” and “taxes go nowhere”. My point is that there are simple finance descriptions for putting this demystification effort into more standard phraseology, without necessarily jeopardizing the value of MMT insights into the nature of the monetary system.

      For example, the reason taxes seem to go “nowhere” is that government income (taxation) at the transactional level is used to reduce financial liabilities (it reduces reserves in the current system). Taxes go nowhere in the same way that income used by a household to pay down its mortgage goes nowhere. There is no substantial reason to reject terminology such as “income” or “saving” when describing government financial activity.

      (It is counterproductive in my view to debate whether or not something that appears on the liability side of a central bank balance sheet, such as reserves, currency, debt, and tax credits, is a liability or not. That sort of debate is not the point. There can always be a response to it, as in my example earlier. The important idea is some reasonable and practical coherence in explaining monetary operations in their full scope, without resorting to the “nowhere” type of vocabulary. Once that is cleared, it seems to me the more powerful ideas in MMT focus on the rejection of monetarist thinking in understanding the inflation process, and the inclusion of a real constraint centered framework (employment and capacity).)

    7. Anon,

      There are Post Keynesians who have written in detail in the way you have described.

      You are discovered Post Keynesianism by youself. Very nice.

    8. Thanks for your considered reply Anon,

      I think I do get most of your points. I sense (to a large extent) you are striving for correctness in terminology. Which is important explaining and selling MMT to a highly educated audience.

      You say.

      The question then becomes, what is the issuance limit for government? MMT responds that there isn’t one –

      I’m sure MMT is correct in it’s logic, but I also feel there must be a point at which the social utility of an expansionary policy is impaired by excessive spending. I would regard this as a form of constraint. Why spend so much you do more damage than good.

    9. That is why Warren is always quick to say ‘not operationally constrained’, no? Only constraints are real? Doesnt that cover it?


    10. (quick partial version of much longer unpolished post):
      Anon: As MDM and I have brought up, the book to consult is the one Wray edited on Mitchell-Innes. In particular the phrase MDM quotes – all money is credit, but not all credit is money. Individuals do not issue (high-powered) money / currency = Government Credit, but personal credit – e.g. Anon-money. Yes, you can create net financial assets for the rest of the world, but they are your liabilities, of interest only to you and your creditors – not government liabilities, not NFA the way the term is usually used here. They are not currency. That is what happens if you do the split at you vs rest of world, not at the government vs nongovernment. The personal split eliminates all the currency & bonds held by everyone else as it is balanced out by government liability. So it is of no (macro)economic interest, unless you are a government – King of Anonia? :-)

      If you can exchange your personal liabilities for bank money, the bank has the IOU asset you created, you have the bank money, but still nets to zero government money creation. Only when you demand currency for your bank account do you get government NFA, and then the bank’s reserves decrease by the same amount. No net effect. Only if you cause discount rate borrowing – realistically only if you are a bank – will you be able to willfully cause the creation of new government NFA, which always necessitates government action, as Bill indicated, September 24, 14:11. When Bill says “net financial positions denominated in the currency of issue” he means net financial positions of the nongovernment relative to the government of course. Such pedantic clarifications need to be said and understood once; to repeat them always would make everything unreadable. And of course, no one, not even God can change the true net financial position of every entity taken together. It is always Zero – The same good old zero that appears on those sector balance equations.

    11. Paradigm Shift: The semantic to-and-fro about “spending by crediting bank accounts” got me a bit lost, I must admit. It seems to me that both commercial banks and the government spend by “crediting bank accounts”, but that the difference lies in the consequences of the change in equity of the entity doing the spending, since, unlike commercial banks, the gov/CB can (I assume) operate with negative equity. Or am I missing something?

      The government can do whatever it allows itself do. The CB can operate with negative equity for the simple reason that government accounting is a fiction relative to nongovernment accounting. The terms do not apply in the same way in real terms. Negative equity for nongovernment is a big deal, but no problem for government. Governments regularly operate “at a loss,” e.g., in deficit; therefore, they build up massive debt that gets rolled over. The Treasury cannot run out of money and the CB cannot go bust. That’s why an “MBA/CEO president” is a joke. The state is neither a business nor a bank. It is a social and political institution that human beings developed in order to meet social and environmental needs.

      The real issue for government is managing money relative to real resources in order to balance private sector needs and “happiness” with promoting public purpose. Government creates state money, and banks are allowed (chartered) to participate in this process through loan creation (which puts capital at risk) at the pleasure of the government, since they are public/private partnerships operating under government charters.

      What is the government’s actual equity? The ability to tax. If effect, the state owns everything through its ability to tax. Libertarians are quite well aware of this.

      Government accounting is the way that government accounts for operations. It is in control of its operations in a way that nongovernment is not. However, government chooses to use accounting procedure that mimics nongovernment accounting procedure. That should not cause us to confuse government with nongovernment operationally when there are hierarchies operative that result in essential differences. Therefore the accounting terms are analogous at best, if not equivocal.

    12. Some Guy,

      King of Anonia works for me.

      As does the Anonia/non-Anonia sector financial balances model.

      I wouldn’t be making these comments if I wasn’t already quite familiar with what MMT says. I know what it says. I’m just offering a different slant on it.

      You got the message right on the split possibilities. That’s good. The government/non-government split may well be the most important one, but it’s not the only one.

      But I’m not sure you’re getting what I’m driving at on currency issuance.

      Again, consider the alternative architecture, not only with no bonds and not only with a combined central bank/fiscal treasury function, but with no commercial banking. There is one single banking entity that performs all required banking functions, and that bank is embedded in the institution of government. MMT must allow for this possibility. Let’s call the banking function the national bank.

      So with regard to currency issuance, what you have is government deficit spending, resulting in non government deposits appearing in the national bank (there are no longer any banking system reserves required).

      I go to the same national bank to get my consumer loan. I spend that money into broader circulation.

      I’m in the same position relative to the national bank’s creation of money as is the government. It’s my spending that has been the reason for the creation of new money by the bank, the same as the government.

      I have my credit limits.

      The government may consider itself to have limits according to “real constraints”, or limits as dictated by Congress, or whatever. The point is that there is a process for dealing with the issue of limits, one way or another. In the case of government, somebody has to deal with the issue of translating real constraints to financial limits, at some point. (One of the unspoken debates within MMT is whether you attempt to deal with that issue now or later. The default MMT position is always later, it seems.)

      Thus, there are limit processes for myself and the government. The two processes are quite different. But they operate in parallel. And apart from those limits, there is no barrier to operational money creation by the national bank – whether the ultimate cause for the new money is myself or the government. In that sense, I’m not subject to an operational constraint any more than the government.

      Bank reserves are not ground zero for this type of analysis, because bank reserves are merely an artifact of a competitive private sector banking system. MMT thinking should hold up whether or not that’s in place.

    13. Anon –

      You say the starting point for MMT logic should be non-govt being constrained by credit risk vs govt constrained by real resource issues. I don’t find the contrast that compelling – and I’m still not sure why you think this is THE relevant contrast to draw. Govt carries the power to levy taxes (which ensures a demand for the currency, in addition to the legal obligation to accept it inherent in any fiat currency). What is the equivalent to this power in your non-govt analogy?

      I appreciate your focus is on moving people away from focussing on the quantity of money; but otherwise, what is your agenda with respect to MMT?

      If MMT has an agenda in the real world right now, I would imagine it’s something like liberating popular and policy-makers’ opinion from a fear of budget deficits in excess of 10% of GDP. If you broadly accept this agenda, I’m not sure why you are pushing a “different slant” on the existing way of setting out the MMT logic.

      Finally – if you could also try a mite harder not to sound patronising in your comments, that would be splendid. We have plenty of that already from Ramanan.

    14. Anon: Again, consider the alternative architecture, not only with no bonds and not only with a combined central bank/fiscal treasury function, but with no commercial banking. There is one single banking entity that performs all required banking functions, and that bank is embedded in the institution of government. MMT must allow for this possibility. Let’s call the banking function the national bank….

      This is a proposal that is out there, being advanced by some people, as is a proposal for bank money only, excluding state money. MMT is presently dealing with the global monetary system that is in place, i.e., sovereign nations as monopoly providers of nonconvertible floating rate currency, and also with the various variations on that theme that are also in place. Should the US adopt a different system, like no bond and Treasury overdrafts, or a national banking system with a single bank, or abolish the Fed and move to commercial banking only, MMT will have to deal with that. After all, the EZ and euro already stretch the bounds of the present monetary regime, and MMT is dealing with that. So, I agree that MMT principles should be applicable to thought-experiments, and I suppose that MMT economists would also.

      Economics deals with the factors of production, distribution and consumption of real resources. Money & banking, and finance in general are supposed to support those ends. So iit comes down to real resources, with money used as a way of exchanging them, keeping score, postponing resource use through savings, and drawing resource use forward through credit. State money also serves as the means for the state to allocate resources to itself without seizure, although some would claim that taxation of private property constitutes seizure.

      There is obviously a difference between a system with state money and one without it. MMT claims that the latter is pretty much irrelevant since it has not be significant historically and is not likely to be in the future. So analyzing an economy with state money becomes the issue for Chartalists. Chartalists see state money as divided into two monetary regimes, convertible/fixe rates ones and nonconvertible/flexible rate ones. MMT calls the latter “modern.” So MMT is the analysis of the use of state money in a nonconvertible floating rate system. To do this is uses 1) a description of government operations involved in the creation and control of state money, and 2) stock-flow macro models to analyze the production, distribution and consumption of real resources based on reporting of financial transactions. Depending on the quality of the data, this more or less reveals what is happening in the real world and what can be expected based on trends, as well as what is likely to happen if certain policy options are implemented.

      MMT aka Neo-Chartalism is about the employment of state money, and this is the focus of MMT. Indeed, MMT economists seem to take the vertical-horizontal relationship of government and nongovernment as foundational. If there were no nongovernment banking system, then that relationship would not pertain. But even with one, the money that is used is state money in the sense that it can be used as legal tender at government payment offices, even if it is borrowed from nongovernment. This means that commercial banks participate in the generation of state money along with government as currency issuer. That is a privilege that the state extends through bank charters, which can be revoked by the state. The state could operate with state money without extending such charters.

      According to MMT, the real constraint on government is the availability of real resources, both for its use and the use of the population. Government has to control the monetary system in such a way that real resources remain available for use without generating price instability or social hardship. If it wants to stay in power in a democracy it has to ensure that the population is materially satisfied (economically “happy”) to the degree that they do not turn the government out. Thus, citizens become a real constraint on government, too.

      Individuals and nongovernment institutions are revenue constrained. They have to tap income, sell assets, draw down savings, or borrow in order to purchase goods and services. The monetarily sovereign government is not revenue constrained because it funds itself with currency issuance. There are a lot of ways to slice a pie because a pie has no inherent structure. But institutions matter, and one cannot just slice up an economy randomly. There are significant structures to take into account. What MMT points out, which many people seem to have missed, even economists, is that the vertical-horizontal relationship creates a partition between government and nongovernment financially.

      If I have stated this correctly, I am not sure what you are driving at when you say something like, “…In that sense, I’m not subject to an operational constraint any more than the government.” Your point may be simple but it is eluding me. Both the government and I are operationally constrained by the boundaries of the system, but I am constrained in a different way that the government is. You admit that the government and I operate in parallel. Agreed. The government exists for me as a citizen, not me for the government. Government is an institution created by the state for its administration. In a liberal democracy, the government is said to be “of the people, for the people and by the people.” That, of course, is not the only option. A nation is a system characterized by elements (individuals) and subsystems (institutions) standing in relation to each other and the whole (state, nation), and the whole to them. In a sense, what I do affects the whole system, but all individuals do not have the same impact. The state as an institution stands in the primary and hierarchically premier place with respect to the monetary system, and the people that control the levers of power have a greater impact. There is a “hierarchy of money,” with reserves/currency (state money) at the top of the hierarchy at present.

      Other systems can be imagined that are different, in which case an observer would have to observe them, and someone conducting a thought-experiment likewise. Thought-experiment enables consideration of all kinds of possibilities. I get this, and it is both useful and fun to consider them. But I don’t get where you are going with your train of thought around it relative to MMT. BTW, I don’t take it that you are opposing MMT, but rather that you are tying to make point. I am just not getting your point.

    15. Tom,

      My single bank model does not exclude state money. State money is created in the same way it is now – by deficit spending. Bank reserves are redundant, but currency is issued by the envisaged single national bank as it is now – just without the commercial banking system as distribution agent.

      There is also no damage done to the MMT concept of vertical/horizontal differentiation of money and financial assets. This merely requires a decomposition of the single government/bank entity I’ve described. If that entity has private sector assets, such as my bank loan, that qualifies for MMT horizontal treatment. To the degree that it’s deposits exceed its assets, the difference qualifies for MMT vertical treatment. This is merely a matter of keeping track of the split between the amount of liabilities that correspond to government deficits and the amount that corresponds to the regular private sector banking function. It’s messier, only because treasury, central bank, and commercial banking functions have all been combined into a single entity. BTW, I’ve not seen any MMT proposal suggest that architecture.

      “BTW, I don’t take it that you are opposing MMT, but rather that you are trying to make point.”

      That’s right. The point is the hierarchy for the logic of MMT and its description of the monetary system. I’m proposing a different hierarchy. It’s in my comments above.

    16. Tom,

      It should be clear from considering the operational nature of an integrated treasury/central bank/commercial banking entity that both the government and household customers of this entity can spend money into existence “from nothing” at the operational level.

      If there was no limit on government spending, and if there was no limit on my spending from bank credit, there would be no constraint on either of us.

      Clearly, I am limited – I have a credit limit.

      Is the government limited? Yes – by real constraints. MMT admits that. And it is not particularly illuminating to suggest that the government is not financially constrained when real constraints must obviously be translated to financial constraints in order for them to have any meaning at all in terms of their effect on deficit spending boundaries.

      So we both have limits, and they are financial limits.

      The MMT focus should be about the difference between those limits.

    17. Dear anon (at 2010/09/27 at 10:52)

      You asserted:

      Is the government limited? Yes – by real constraints. MMT admits that. And it is not particularly illuminating to suggest that the government is not financially constrained when real constraints must obviously be translated to financial constraints in order for them to have any meaning at all in terms of their effect on deficit spending boundaries.

      So we both have limits, and they are financial limits

      I consider that is an incorrect statement. There is no intrinsic financial limits on a sovereign government. They are all political and/or real. There is a world of difference between these sorts of constraints and the financial constraints imposed on a non-government spending entity.

      Trying to blur them semantically does not help anyone understand anything.

      best wishes

    18. Currently, the Internet Tzars are trying to implement IP(v)6, which includes 128 bit addressing. From Wiki:

      “The very large IPv6 address space supports a total of 2E128 (about 3.4×10E38) addresses—or approximately 5×10E28 (roughly 2E95) addresses for each of the roughly 6.8 billion (6.8×10E9) people alive in 2010. In another perspective, this is the same number of IP addresses per person as the number of atoms in a metric ton of carbon.”

      Now when this is implemented, the global govt internet Tzars will probably think they are unconstrained in their ability to assign internet addresses….Anon may think otherwise.

      Anon may think this because humanity can never manufacture NIC cards at a Flow measure that will ever be able to reach this total number. So Anon would say there is a constraint, the ‘real’ capability of the electronics industry to achieve a certain NIC card manufacturing Flow. But the internet Tzars who are running out of addresses would care less as their problem would be solved and manufacturing of NICs would never have to shut down due to lack of addresses.


    19. I’m just jumping into the ring with the big boys for a bit of comic relief.

      In the left corner weighing in at 300lb and 6’7″ we have the all empowered state bank.

      In the right corner at 300lb and 4’8″ we have a fully privatised banking system.

      Interesting fight but they are good at different things and both have unique problems. E.g. Private banks will manage the day to administration of household loans more efficiently than a State bank. Private banks don’t manage aggregate risk very well.

      We shouldn’t argue the extremes but look to create the ultimate fighting machine (A happy balance).

      Why can’t we all just get along……:(

    20. Anon:

      there are limit processes for myself and the government.[…] And apart from those limits, there is no barrier to operational money creation

      Since ‘barrier’ and ‘limit’ are synonyms, your statement seems inconsistent, prima facie at least. One might assume that what you wanted to say was :”apart from those limits (whatever those limits might be) there are no other limits to money creation”.

      One would rather not assume though, but wait for an explanation of that odd statement.

      Parenthetically, the mono-bank system you describe is not a theoretical construct but an actual system that was implemented and used in the USSR between 1933 and 1987, under the name of GOSBANK, without any complications of the interbank market whatsoever. Are you proposing the GOSBANK system as an MMT option ?

    21. Matt,

      I’m not very familiar with the technology of your analogy, but it seems to me the difference is that the internet Tzars have not assumed there are real constraints to their expansion process. As I understand it, MMT does assume real constraints are possible if not probable.


      It could be an option although I would not propose it as a selection. Your replacement sentence structure is quite OK.

    22. Anon:

      Thank you for the clarification.

      Regarding the limits. In the hypothetical no-bond/merged CB+treasury universe, what number or a set of numbers would represent the government money creation limit ? If such set of numbers would exist in the NB universe, what specific tools and government structures would be used to control government money creation in a reliable and predictable way ?

    23. VJK,

      This may seem like a bit of a “cop out”, but I don’t think we know what the limit is, at least not in a very straightforward sense.

      The murky area to me is that if we believe that there are real constraints to deficit spending, then those real constraints should affect decisions regarding a policy upper bound for deficit spending at some point – i.e. at the point that those constraints become “binding”. The aspect I then struggle with about MMT is that I wonder how such decisions flowing from the activation of real constraints actually enter into the process over time. Is this a sudden adjustment, or is there an element of anticipation, planning, or gradualism involved in starting to execute the idea of limits or upper bounds as the real constraint starts to bind?

      So the idea of a “limit” is somewhat soft, compared to the harder limit of a maximum credit allowable for a household.

      Still, this is the sense in which I’m suggesting there is a parallel.

    24. VJK and anon, I think we have already passed a global limit for government money issuance. The governments may be operationally able to issue money in an unrestrained manner but the economy can only cope with a certain ratio of money in savings versus wages/consumption. Once the size of the real economy is dwarfed by the amount of money in savings, then capital allocation stops leading to the appropriate resource allocation that the real economy requires. The economy breaks down into a ponzi mess which is what is happening.

    25. Anon:

      Thank you for the thoughtful response.

      Broadly, the considerations you have outlined are what bothers me too.

      I don’t think we know what the limit is, at least not in a very straightforward sense.

      Metaphorically speaking, it seems that the Mosler car may be set in motion without a speedometer and the brakes with both the engineer and the mechanic running alongside and trying both to design and mount missing pieces in vivo.

    26. Vjk,

      MMT Proselyte has already accused me of sounding patronising plus I have debated this many times with no empathy. Some commenters may accuse me of advocating the “twin deficits” doctrine. I must admit that I believe in it – though in a complicated dynamical way. However, see the blog post “twin deficits and other neoliberal myths” (don’t remember the exact title).

      My views are quite opposite of MMT on this.

      A nation has more fiscal capacity than what neoclassicals think but I think that there is one more constraint than the real constaint. That’s the balance of payments constraint.

      Nations cannot ban imports because it goes against WTO rules. A good way to do a fiscsl expansion is to promote exports. Of course, it is silly to behave like China and peg your currency to a super overvalued number and transfer resources to the US. Some nations are lucky – the continue to attract foreign inflows to finance the trade deficit. However, this process is sustainable as long as the foreigners allow it to go on. The external world is a big constraint on fiscal policy.

    27. Ramanan:


      I think that there is one more constraint than the real constraint

      How would you quantify “the real constraint” ? We’ll deal with CA/KA business later ;)

    28. Vjk,

      Neoclassicals think that fiscal policy is useful only temporarily and economies are mostly supply constrained. Money is neutral both in the short run and the long run in this picture and hence inflation is anywhere and everywhere a monetary phenomenon. They do not know how the money supply changes and conjecture things like the central bank printing money etc. Deficits are said to cause inflation because it is thought that the central bank monetizes some of the debt. This picture is wrong!

      Moneterists won over Keynesians in the 70s because in that time wages increased – this caused firms to borrow more, causing the money supy to rise – because loans make deposits etc. Higher wage rates meant higher costs for firms and hence increase in prices. This caused workers to demand higher wages and it turned into a mess. Milton Friedman became popular while he convinced policy makers to reduce deficits and the money supply. The central banks increased rates to astronomic levels because direct control of money supply is impossible in practice. In reality they were just controlling interest rates and the high rates led to a recession and deflation. Hence we have the monetarist myth. They confused correlation to causation.

      Inflation happens because of the societal struggle on the share of national income. It can also happen due to other supply factors such as food etc. One may say that inflation is due to rise of wage rates above productivty growth rates. Wages are downward sticky due to wage contracts and hence there is an upward bias on prices. Nobody likes high inflation and Milton Friedman conjectured the NAIRU. In reality its a chimera but there is some truth to it. When employment is near full empoyment – which is never the case – workers may have a higher bargaining power and this may lead to higher prices. However it is unscientific to conjecture that it will lead to accelerating inflation.

      There are various ways to tackle this. For example fast wage increases can be discouraged by taxes. So there are a lot of complications there.

      Also the basic rule has to be kept in mind – the Kaleckian thesis that when demand rises, firms do not increase prices as the neoclassicals say, they increase the quantity.

    29. Didn’t answer your question. Its difficult to quantify really. Governments need to make sure that wages are in line with productivity growth for example. SIngapore does something like that. Don’t know the details. Many things can be achieved by having a proper scientific approach to policy. On the other hand, check Ben Bernanke’s speech recently at Princeton – he says that there is nothing wrong with the present economic theory and he calls it a science!!!

    30. Ramanan: I’m eager to hear criticisms of MMT (not least because MMT appears in danger of suffering from epistemic closure) so can you expand on your BOP constraint please?

      The way Bill, Mosler, JKG2 and Wray outline the real resource constraint, it’s related to aggregate capacity utilisation, irrespective of what the BOP says.

      Anon – appreciate you trying at length to outline your govt/household parallel, but it seems that at least Tom H, Bill and I remain in the dark as to the relevance of your distinction. Do you have a blog where you set out clearly what you are all about, as I’m struggling to follow your myriad posts? Frankly the return on one’s effort expended to engage with your (admittedly intriguing) points makes me feel like you’re a troll, and you may well not be.

    31. Anon: Yes, I get what you are saying, I understand because I thought of these things myself while trying to plumb the depths of MMT. I think some statements are so misleading that some other guys might call them “wrong.” :-) Bill, Tom etc are clearly right.
      I write below at pedantic length to help interested others.

      The single bank = Fed= Treas = government model, which is the essence of the current system makes it clear why “government and household customers of this entity can spend money into existence “from nothing” at the operational level.” or “households and others are effectively currency issuers when they borrow to spend” are not reasonable statements. What the reserve banking / discount rate picture collapsed into the single bank model boils down to is:

      I, Anon, can give the government my IOU for $1 Million. IF I can persuade the gov to lend to me, they can give me their IOU for $1 Million – a government check for $1 Million. But the IF is a very big if, which has been elided. Only if you are a TBTF Bankster – pulling the strings of the government – to many intents and purposes, part of the government, can you do this.

      There are semantic problems in your response, which at one point reasonably conflates the gov/treasury and the bank, and then invalidly separates them to seem to make the central bank the real government, and consider the gov/treasury as just another customer. This has it backwards. The central bank, and any bank, is inessential, dispensable, a recent innovation, and could be replaced by a cookie jar. The monetary/spending/taxing function of the treasury is not, and is indispensible to the concept of money.

      Currency is (a type of) government credit. Government is the monopoly issuer. Individuals can create their own credit, unconstrainedly, to any sum, just as governments can. That is not the difference between individuals and governments. And individuals may be able to trade their own credit with governments for government credits. But there has to be an intentional government action for the trade to take place. They are always the currency issuer.

      Unlike individuals, governments can issue credit not only in their name. They can write U-O-Me’s – IOUs in your name, payable to the government, without your intent or action. These are called taxes, and are what ultimately give government credit (unlike personal credit) intrinsic tradeable value for real world objects and services. The government can issue gov-credit and anon-credit, while anon can issue only anon-credit. My earlier comparison was a check-kiter, who is also a forger. Some guy who can make perfect, enforceable forgeries – checks from others to back up his kited checks, has the financial power of a government. So there is no meaningful way individuals are currency issuers. Neither individuals nor governments have intrinsic purely financial constraints. But because of government’s taxing / forging power – at any moment it can buy all the stuff in its legal reach – only governments are constrained only by real physical limits in the interaction of the financial world with the real one, in its capacity as a buyer confronting sellers.

      The reason comparing silly rules like positive treasury balance, no monetization, head of the Fed must be a middle aged white male rather than a chimp (cf a Wray blogpost), etc to credit limits is simple. It’s comparing apples and oranges. Getting a bank loan of bank/government money in exchange for personal credit is borrowing. Government “borrowing” – issuing bonds to trade for currency is not borrowing. Government spending in return for private stuff is closer to private borrowing. Government “borrowing” in its own currency is constrained because it is a logical impossibility. You cannot borrow your own credit from someone else. Government “borrowing” is closer to making change – the Treasury trading its hundred dollar bills it created for a hundred of the one dollar bills the Fed created than it is to real borrowing. Mark Twain’s story “The Million Pound Note” or the Gregory Peck movie might be helpful to get in the right frame of mind. And just as the government could have “no bonds” policy, it could have a “no currency” policy, or put any crazy condition it wanted on its credit.

      And so conclusions like “That difference is more constraining on governments than it is on households.” are not just wrong, but hardly intelligible.

      @MMT Proselyte:
      Anon is not being a troll. However, imho he is not being precise and careful enough and so is saying things which may be interpretable as true, but in the natural interpretation, are not. Like individuals being “currency issuers.” Exactly what they are not and can never be.

    32. Some Guy,

      Thanks for your comment.

      I said earlier:

      “my observation is that households and others are effectively currency issuers when they borrow to spend”

      Not being quite sure that I said something like that, I looked for the reference based on your comment.

      That what I said. And yet the single bank model actually highlights the fact that the issuing entity is effectively the government – so you are quite right to criticize such a statement on that basis.

      So the question (for me as well) is what was I thinking in making such a statement?

      I did say “effectively”. What I meant by it is that both the government and the household are using a banking function in such a way that it causes the bank to issue currency. If you separate the aspect of who is causing the currency to be issued from the aspect of whose credit is backing the currency issued, then my point may become a bit clearer. While the credit backing of the currency issuance is clearly the government, both the household and the government can cause the currency to be issued. The case of the household being the causal agent is the sense in which I used the word “effective”.

      But you’re right to criticize, at least because it was a misleading statement (unintentionally), and there should be a better and more accurate way of expressing this thought.

    33. anon, when you credit-spend and thus create “money” you actually issue not your money but other money which is government money. The step that is missing in your logic is that your bank converts your money into government money and settles your transactions for you when you pay for goods and services. But you still have to pay back your credit and it happens not with your money but other money, government money. This is what your bank will accept as repayment. That is precisely the reason why private sector is credit constrained but government is not. The banking and settlement system and central bank on top of it all constantly make sure that conversion rates are all par. Otherwise somebody is not viable and has no more credit.

      If you can devise a case when private liabilities are worse more than government (so conversion is above par) then I would be happy to hear. As far as I can see the risk is only to the downside up.

    34. “your logic”

      Both households and government create bank money when they deficit spend.

      Both are constrained and face financial limits.

      Households are constrained by credit risk; governments are constrained by inflation risk.

      As a result, there are financial limits to both.

    35. I’m pretty interested reading this views of yours. I have a thought that what if the Federal Government borrows a large amount of funds. This may crowd out other potential borrowers and the interest rate might bid up by the deficit units. In other words, the fiscal budget deficit in large scale resulting in higher interest rates. Doesn’t it?

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