Budget deficit basics

I get many E-mails every week from people asking me to explain exactly what a deficit is. They understand that a budget deficit is the difference between revenue and spending but then become confused as a result of being so ingrained with narratives emanating from politicians and lobbyists who misuse terms and always try to conflate deficits and debt. So today’s blog is a basic primer on deficits and why you should welcome them (usually) and why we all should sleep tight when the government is in deficit. So – budget deficit basics …

There were two recent articles in the Wall Street Journal that motivated me to write this blog today rather than another time. They were examples of political statements which completely abused the underlying economic concepts being discussed and therefore mis-informed the public debate.

In doing so, they self-reinforced illegitimate economic concepts and further placed the respective economies being focused on in further jeopardy.

The first (April 1, 2011) – Japan Government Slams Calls For BOJ Underwriting Of Public Debt – reported statements by the top-ranked ministers in the Japanese government in relation to how the resources need to pursue the earthquake and tsunami reconstruction effort would be garnered (paid for!).

The opposition Democratic Party of Japan has signalled that the “concerns over the impact of BOJ underwriting are overblown”. The DPJ want the Bank of Japan (central bank) to “print more money to underwrite government bonds–a step that would require approval by the parliament”.

I recently considered the reconstruction issue in this blog – Earthquake lies and then specifically, the issue of the Bank of Japan directly buying Ministry of Finance debt in this blog – We’re sticking to our strict fiscal rules.

The WSJ article first quoted the Finance Minister Yoshihiko Noda who said:

The government isn’t considering … [any direct central bank financing of public debt official must be] … very, very careful going forward …

The WSJ also said Noda noted that “long-term interest rates rose as soon as a report that lawmakers were considering direct BOJ bond purchases was published electronically Thursday”.

The reference to long-term interest rates is an attempt to say that the “markets” fear inflation would result from the direct purchase of public debt by the Bank of Japan. Long-term interest rates depart from short-term rates by some risk component and long-term inflationary expectations.

Rising long-term yields on public debt may also signal an improving economy which leads bond investors to diversify their portfolios into riskier financial assets and so the demand for public debt drops and yields rise.

Long-term bond yields are at historic lows at present and small upward corrections in yields do not mean that the bond markets are fearing an inflation outbreak any time soon.

The yield on 10-year notes (currently at 1.3 per cent) has already crept up by nearly 10 basis points over the last 12 months but remains well below the average over the last 25 years (around 2.75 per cent). Just before the property crash in 1990, the bond yield for 10-Year notes was 8.23 per cent. As the deficits expanded in the late 1990s to restore growth the yields plunged and by June 2003 had reached a record low of 0.45 per cent.

The WSJ also reported that the Economy Minister Kaoru Yosano said that “having the central bank underwrite government securities” would be:

… unthinkable, and I won’t let it happen, no matter what … such action, ignoring fiscal discipline, the Japanese government and the BOJ would lose international credibility … I can’t even forecast how that would ricochet against long-term interest rates in the market.

The question arises that why would international credibility matter (about what anyway?) when Japan places almost all of its debt in the hands of domestic investors who cannot get enough of it?

But these ministerial statements are merely political statements reflecting the hold that neo-liberals have on the policy debate. There is no credible economic content to the statements.

I note that today – the first trading day after the Ministers made their statements about re-affirming their commitment to “fiscal discpline” (conservative-style) that the – Japanese government yield curve – has flattened a bit (short-term yields down and long-term yields up).

If these movements last week really reflected the fear that inflation was about to become a problem in Japan as a result of speculation that the central bank might start directly buying Ministry of Finance debt, then the yields should have fallen this week as a result of the strong statements from the two senior economic ministers.

The point is that these movements have nothing to do with the speculation that the BOJ might exercise its legal right and directly facilitate Japanese government spending without forcing it to match the deficit by debt-issuance into the private bond markets.

The misunderstandings were not only on the conservative side of Japanese politics. The WSJ article quoted a senior DPJ Upper House politician Yoichi Kaneko who said:

The only negative aspect of BOJ underwriting is that prices will rise because of money being spent by the government flowing into the market … I can’t imagine that long-term rates will climb …

So the “progressive” is a quantity theorist – the ultimate deception mounted by conservative economists. If public spending caused inflation as a matter of consequence then Japan should have hyperinflation by now. Instead it has been battling deflation for years not as the budget deficit have been maintained.

The article rounded off with hints that the suggestion that the Bank of Japan purchase the public debt has arisen because of insolvency risks:

The concern is that a further increase in Japan’s accumulated public debt–already twice its annual economic output–will likely fuel concerns over the government’s ability to stem its borrowing binge, prompting investors to demand more interest payments to compensate for the risk of holding government securities.

Who is expressing concern here? The bond markets seem content. The people in employment that is being supported by the on-going government deficits are benefiting. The regions that will be reconstructed will benefit.

I just love journalists who cite “the concern” but don’t tell you who is concerned other than a group of over-paid financial market types who want to drive yields on their asset holdings up. The bond markets know that their purchases of Japanese government debt is risk-free – otherwise they would have stopped buying it decades ago.

Historically, long-term bond yields (as noted above) have been very low relative to elsewhere.

But the point is that the article is perpetuating the insolvency risk myth. In one short article, we see the major myths of mainstream macroeconomics in terms of budgets being rehearsed. A solid concentrated dose of lies.

When this sort of nonsense is being peddled every day by a multitude of media commentators it is no wonder that people get confused. Especially when those on the progressive side of politics pump out their own version of the same narrative.

And then you go to a dinner party on a Friday night … and someone there has studied economics somewhere and they spout forth the “wisdom” they rote-learned from Mankiw’s textbook and you spend the rest of the weekend writing E-mails to me asking for some oblation! It is no wonder.

The second (April , 2011) – GOP Aim: Cut $4 Trillion Budget Plan Would Transform Medicare, Reset Budget Debate; Democrats Balk – discussed the 2012 budget proposal by the US Republicans which “would cut more than $4 trillion from federal spending projected over the next decade and transform the Medicare health program for the elderly”.

I don’t intend to critique that article – the points are obvious.

They plan to deny the poor and weak of real resources that are necessary to deliver a modicum of respectability because they claim they cannot afford them. Well they claim that providing this semblance of dignity and security to citizens who cannot otherwise provide it themselves would be “too costly”.

They do not actually understand that the “cost” of these programs is the real resources that are consumed by them. The dollar numbers attached to the programs are meaningless in fact. The US government can always “afford” to “spend” the required sums.

But you will never hear the debate constructed in terms of whether these real resource allocation are possible or not. It is possible that the growing real resource requirements will require political decisions as to whether the US community is getting the best value out of those resources (in that particular use).

That is a legitimate debate but has nothing to do with budget deficits.

Neither side of politics in the US is pointing that out.

Deficit basics

I suggest you read the suite of blogs – Deficit spending 101 – Part 1Deficit spending 101 – Part 2Deficit spending 101 – Part 3 – as background to this blog.

So what exactly is a budget deficit?

It is the net outcome of two broad flows (denominated in the currency that the national government issues) – revenue and spending. What do we mean by a flow? Many economic graduates fail to differentiate between a stock and a flow.

A flow is a variable that is measured per unit of time. So a certain number of dollars being spending per week, month, quarter. If a government was spending $A10 million per day then after a week they would have spent $A70 million and so on. You add flows together to get a lower frequency aggregate (a week is a lower time frequency than a day).

Once a flow has occurred it has gone. It has consequences but a flow is not “paid back”.

Alternatively, a stock is a variable that is measured at a point in time. So a dollar amount at the end of 2010. If there are 1 million people unemployed in January, 2 million in February and 3 million in March – these are stock measures. To get a measure of unemployment in the first quarter of that year (January-March) we would average the individual stock observations to get a value of 2 million.

A stock is a legacy. Flows create stocks and a well-grounded macroeconomic framework has to be stock-flow consistent. Please read my blog – Stock-flow consistent macro models – for more discussion on this point.

So job hires (the number of workers entering a job per period) and quits (the number of workers leaving a job per period) lead to stock measures of employment and unemployment (once we know what the labour force is.

Similarly, depending on specific arrangements in place, a rising budget deficit (the net sum of the revenue and spending flows) can add to the stock of outstanding public debt (a stock) if the government insists of issuing debt $-for-$ to match the net public spending (the deficit). If the government didn’t have these arrangements in place then there would be no particular relationship between deficits and outstanding public debt.

Commentators get hopefully confused when discussing the economic consequences of the flows (deficits) and the stock (outstanding debt).

But when we are thinking about deficits we should ignore the stock associations. From the perspective of Modern Monetary Theory (MMT) the debt implications are an entirely separate discussion which should not be conducted at the same time as we seek to analyse the consequences of the flows.

So when you hear someone say the deficit is too big (whether in absolute terms or relative terms (scaled to GDP)) you should ask them in relation to what

When you read a politician say that “prices will rise because of money being spent by the government flowing into the market” if the central bank bought treasury debt, you should ask two questions: (a) Does that mean that all spending is inflationary? and (b) What difference does the issuance of debt to private bond holders make relative to no private debt placement?

The answers you will typically get are:

1. Yes, deficits are inflationary – which isn’t an answer to the question asked and tells you that the person doesn’t understand the point.

2. Central banks buying debt is just printing money and so there will be “too much money chasing too few goods” and that will be inflationary. But if you issue debt you soak up that private spending capacity and replace it with public spending and that is less inflationary. If you think about that within the flawed logic you might wonder whether government spending would add anything to demand.

A mainstream economist however will approach the matter in a more analytical manner. I recently wrote (again) about the government budget constraint literature (GBC)in this blog – How are the laboratory rats going? – and so I only state the conclusions here without explanation. You are encouraged to refresh your memory by re-reading that blog.

The mainstream think that the government has to “finance” its spending just like a household. The government is just like a household but bigger from the perspective of a mainstream economist – a super-household.

So they then move onto analysing the “financing” choices of government and integrate these options in their analysis of the consequences of government spending.

To restate, the GBC equation is written as:

gbc

which you can read in English as saying that Budget deficit in year t (BDt) equals Government spending (G) + Government interest payments (rBt) – Tax revenue (T) which in turn must be “financed” by the change in public debt (B for bonds) and/or a change in high powered money (H). Here r is the interest rate on outstanding public debt, and Bt is the stock of bonds outstanding at the end of the period in question.

The triangle sign (delta) is just shorthand for the change in a variable and the little t next to the variables refers to time period t (that is, now).

Note that Bt is a stock but rBt is a flow because if, say, r = 0.05 and Bt was $A100 million then rBt would be a flow of government spending equal to 5 million in that particular period (t).

The change in high-powered money would arise if the option that is being discussed in Japan at present – the Bank of Japan directly buying Ministry of Finance debt – was used.

The change in bonds would arise if the government sold bonds $-for-$ (yen-for-yen) into the private market to match the excess of government spending plus interest payments over tax revenue.

The important point is that mainstream macroeconomic theory considers that the consequences of the net public spending differ according to whether the spending is associated (funded in their parlance) by ΔB or ΔH.

Modern Monetary Theory (MMT) disputes that claim.

In terms of stock-flow consistent macroeconomics, the equation above will always hold and in saying that I am not ascribing any particular significance to that result. As long as all the transactions between the government and non-government sector have been correctly added and subtracted then the budget deficit described above will always be reflected by the sum of the changes in ΔM and ΔB.

That is, in terms of MMT, the GBC equation is just an accounting identity that has to be true by definition once all the transactions are accounted for (that is, ex post or after the fact) and has no real economic importance. The spending has significance but the monetary operations (the ΔB and ΔH) do not.

But for the mainstream economist, the equation represents an ex ante (before the fact) financial constraint that the government is bound by. MMT proponents note that this cannot be true as a matter of intrinsic capability if governments issue their own fiat currency. It is clear from my blog last week – We’re sticking to our strict fiscal rules – that the Bank of Japan can facilitate (term used in place of “fund”) government spending directly and the private sector doesn’t have to buy any debt.

Yes, ΔH will rise as an accounting reality but given the Bank of Japan is really part of the consolidated government sector it is nonsensical to consider that as a “financial constraint”. Please read my blog – The consolidated government – treasury and central bank – for more discussion on this point.

It is true that governments might place voluntary constraints on themselves for political reasons – as in the statement made by the Japanese Economic Minister noted above. There are many ideological constraints – justified by the call for imposing fiscal discipline – that governments use to make the operational realities of the fiat currency system more elongated.

But they can be dismantled in the same way they were imposed – by discretionary choice. They are not financial constraints in the way the mainstream textbooks suggest. Please read my blog – On voluntary constraints that undermine public purpose – for more discussion on this point.

From another perspective – the justification used for these voluntary constraints is rather wan to say the least.

The statement by the Japanese Economic Minister – “such action, ignoring fiscal discipline” – is representative of the arguments that have been made following the collapse of the Bretton Woods system in 1971 to justify continued debt-issuance to the private sector – when in operational terms there is no reason to issue such debt.

Under the fixed exchange rate, convertible currency system that ruled up to 1971 (in the Post World War II period) governments were financially constrained. After 1971, most government shed those shackles in operational terms but were pressured by conservatives to continue limiting their fiscal latitude.

But think about it for a moment. These politicians are seeking out vote and then telling us they cannot be trusted to exercise the power we wrest in them. It has always been a nonsensical contradiction.

Anyway, the mainstream economists debate the choice between ΔH (change in high powered money) and ΔB (change in bond issuance) in this way.

The standard framework compares public spending backed by:

  • Tax revenue (that is, balanced budget spending).
  • Bond issuance (that is, ΔB).
  • High powered monetary growth (that is, ΔH).

They claim that the degree of expansion is greater with the third option relative to ΔB, which, in turn, is more expansionary than no deficit at all.

The result that ΔH is most expansionary is based on several flawed assumptions and understandings. They claim that the central bank controls the money supply – because there is a money multiplier operating that links changes in the monetary base (ΔH) to changes in the broader money supply.

They claim that interest rates are determined by the private demand for money relative to the supply of money and under usual conditions when the government expands high powered money, interest rates fall which stimulates private spending in addition to the government spending.

They do claim that the government spending increases the demand for money and pushes interest rates up but the monetary accommodation (ΔH) offsets this to some extent. The debate then is about the extent of these effects.

They compare that with debt-issuance which they say leaves the money supply unchanged and so the only monetary effects are an increasing interest rate (via the government spending pushing up interest rates) which chokes off private spending. This is the crowding out effect. The public spending crowds out private spending.

The extent to which this happens is debated at length (this is what mainstream academics write endlessly about) with moderate mainstreamers allowing government spending to be expansionary but less so than the monetary expansion because of the crowding out effects. The extreme mainstream economists believe the crowding out is 100 per cent. Ricardian Equivalence is a version of that extreme view.

The mainstreamers then say that as high powered monetary creation is the most expansionary it should be eschewed because it will be inflationary. They invoke the Quantity Theory of Money here – which claims there is a direct and proportional relationship between monetary growth and inflation. They forget to remind everyone that the result could only hold if there is full employment (and some other assumptions that also rarely hold).

The problem is that the myth has become part of the folklore that we operate in and so you even hear progressives mouthing that concern (as noted above in the Japan example).

As an aside, by recognising that central banks can directly facilitate government spending without recourse to the private debt markets the mainstream are really admitting there is no financial constraint on government spending. That is why they are so vociferous about inflation.

There are so many errors in logic and fact in the mainstream argument – among the key problems:

1. Central banks cannot control the money supply. Please read my blog – Understanding central bank operations – for more discussion on this point.

2. There is no money multiplier – please read my blog – Money multiplier and other myths – for more discussion on this point.Second,

3. Expanding high powered money does not cause inflation. Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.

4. The central bank sets the interest rate – please read my blog – Will we really pay higher interest rates? – for more discussion on this point.

5. Increased government spending does not put upward pressure on interest rates – please read my blog – Will we really pay higher interest rates? – for more discussion on this point.

6. The national government does not have a financial constraint and the monetary operations that might be associated with government spending does not alter the impact of that spending.

The government spends the same way irrespective of these operations. It credits bank accounts (or indirectly credits them by issuing cheques). This spending adds to aggregate demand and boosts employment and output – as long as their is increased capacity.

The reality might be that the treasury may instruct the central bank to credit some bank accounts and some intra-government accounting record would be altered. The accounting is of no interest to us economists in this context.

Alternatively, the treasury might instruct some other government agency to put out a bond tender to match the spending increase. The spending still occurs in the same way and then the accounting for the debt issuance is a bit different (as we will see) but of no significant to that spending.

The mainstream claim that high-powered money creation (depicted as the government asking the central bank to buy treasury bonds which the central bank in return then prints money) means that the extra spending will cause accelerating inflation because there will be “too much money chasing too few goods”.

But in fact the economies will respond to aggregate spending increases by expanding output unless they cannot do that. When might that be? At full employment. In which case, why would a government continue to expand nominal spending if they know they cannot tease any more output (and employment) out of the real economy?

Most economies are typically constrained by deficient demand (defined as demand below the full employment level) and so nominal demand increases (growth in spending) will not lead to inflation.

So when governments are expanding deficits to offset a collapse in private spending, there is plenty of spare capacity available to ensure output rather than inflation increases. You will also appreciate that the inflation risk comes from the spending – not what accounting gymnastics are performed – that is, whether the government “borrows from itself” (exchanges of accounting information between treasury and the central bank) or borrows from the public (swapping a bank reserve for a bond account).

So these monetary operations (high powered money creation/debt issuance) neither increase or decrease the risk of inflation associated with the spending. What matters is whether there is spare capacity in the economy to increase production when a spending increase enters the economy. If there is then the inflation risk is low to non-existent.

If there isn’t then the inflation risk is high – bond issuance or not!

But what about the argument that bond issuance is less expansionary because it soaks up private spending capacity?

What would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a budget deficit without issuing debt?

Like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.

The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made. Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet). Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.

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

When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target. Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.

These debt sales do not “finance” government net spending – they are a monetary operation aimed at interest-rate maintenance. So M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. It is this result that leads to the conclusion that that deficits increase net financial assets in the non-government sector.

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

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

There is no difference to the impact of the deficits on net worth in the non-government sector.

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

However, reflect back on the errors of logic outlined above in the way the mainstream macroeconomists use the GBC:

  • Building bank reserves does not increase the ability of the banks to lend. They do not need reserves to lend. Banks will lend if there are credit-worthy customers irrespective of the operations that accompany government net spending. Please read the following blog – Building bank reserves will not expand credit.
  • The money multiplier fails to adequately describe the credit creation process – that is, the way in which banks make loans.
  • Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process. Please read the following blog – Building bank reserves is not inflationary – for further discussion.

None of this leads to the conclusion that budget deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity. It might be that in your example a 6 per cent deficit with full employment might be too expansionary.

There is nothing a priori that would suggest that. There is nothing intrinsically interesting about a 6 per cent deficit or a 2 per cent deficit. It all depends on the spending contributions from the three sectors (government, external and private domestic).

If a 6 per cent deficit – which is a flow of spending – was adding too much to aggregate demand (spending) at full employment and wasn’t just offsetting the demand drains coming from the external sector (trade deficit) and the private domestic sector (saving overall) – then MMT provides clear guidelines for policy.

As long as the government is happy with the political private-public mix of activity then it would cut back its deficit to avoid pushing demand into the inflation barrier. If it wanted more public activity and less private, it could do that by increasing taxes and deprive the private sector of disposable income.

But the assertion that the private placement of debt reduces the inflation risk is totally fallacious. It does not.

Conclusion

I hope this clarifies some of the burning issues that are current but very obscured by erroneous public commentary.

Budget deficits do matter because they are the way the government can add to aggregate demand and influence real output and employment levels. If they add too much nominal demand then the government will cause inflation. It is really very simple.

But the actual budget deficit outcome that is associated with maximum output and employment is of no significance. The only legitimate goal that government should pursue is the real goals – employment and output – focusing on some given (fiscal rule-driven) budget outcome will likely thwart that legitimate activity.

That is enough for today!

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    55 Responses to Budget deficit basics

    1. I agree that high powered money (HPM) creation is not inflationary given less than full employment. But I agree with mainstreamers when they claim that HPM is more expansionary than government debt, dollar for dollar. The reason stems from the fact that debt pays interest, whereas HPM pays little or no interest. The total amount of debt plus HPM the private sector is willing to hold before it tries to dissave HPM (i.e. go on a spending spree) will be decline if the HPM constituent of “debt plus HPM” rises.

      Warren Mosler makes pretty much the above point in his “Soft Currency Economics” when says in relation to his parent, children and business card analogy, that if the parents raise interest rates, the children will save more business cards.

      Mike Norman claimed recently that government debt can be more or less wiped out simply by printing money and buying back the debt. His basis for this claim is that, like Bill, he thinks HPM and debt are near identical. Again, I don’t agree. But that’s not to write off the “print money and buy back the debt” idea. It just means (if I’m right) that one would need a dose of some sort of deflationary measure (e.g. a tax increase) to counteract that stimulatory effect of printing money and buying back the debt.

      Mike Norman’s posts are here: http://mikenormaneconomics.blogspot.com/2011/03/simple-way-to-pay-off-national-debt.html

      And here: http://mikenormaneconomics.blogspot.com/2011/03/winning-how-are-we-going-to-pay-it-back.html

    2. anon says:

      “These debt sales do not “finance” government net spending”

      Well, they do, under the “self-imposed” accounting constraints of an independent central bank.

      Most of us know what you’re saying, but you’re FOREVER going to get blow-back from somewhere on this issue until you become absolutely crystal clear on which system you are talking about in a given context – the existing one with all its “self-imposed” accounting machinations, or an imagined one with a consolidated operation.

      The way to clear this up most effectively is to reorganize your presentation into existing and proposed systems.

      “What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending.”

      Of course it reduces deposits, if bonds are sold to non-banks, which most are on a net flow basis.

      “It might be that in your example a 6 per cent deficit with full employment might be too expansionary.”

      Cut and paste from the Krugman response?

    3. Dan says:

      I agree with Anon. You need to construct why we have a deficit/debt and then deconstruct the system and offer potential solutions. I also think it is important to state why we have the rules we have. Anon stated the we have self imposed constraints but people need to know why they exist. This fills in the conversation and helps with the understanding and acceptance.

      Also I would suggest that up front in you articles make you point in simply and succinct (very non-technical). Then go into detail and then have you conclusion. To a lot of people monetary policy is new and you ideas are new.

      These are just my suggestions.

    4. Neil Wilson says:

      “The total amount of debt plus HPM the private sector is willing to hold before it tries to dissave HPM (i.e. go on a spending spree) will be decline”

      I think that’s looking at the horse from the wrong end.

      Firstly you need evidence that there will be a spending spree. The interest at the short end of the economy has been slashed massively in the last three years. Has there been a spending spree as people clear out their savings? I haven’t noticed one.

      The central bank was praying for a spending spree to save the economy, but it hasn’t happened. In fact cutting the rates may well have increased the amount of saving as people feel less secure and businesses can’t find anything to do with their money.

      Secondly even if people do start saving less, then that is exactly what you want to happen. We are where we are with a massive shortage of demand. Stopping issuing government bonds sounds to me like a quick win. Either it’ll start a spending spree, which would be great and would increase the tax take, or it won’t – in which case the government has ‘saved’ some money in interest. Both approaches may give the government some political room to cut taxes/increase spending in the current climate. I suspect that the government direct injecting the money into the economy is more likely to generate flows than paying out bond interest (which I reckon gets stocked pretty quickly).

      The elephant in the room of course is the effect of removing the interest on the exchange rate. We’re about to see in the UK how a sharp devaluation of the currency against a main trading partner is going to play out in reality.

    5. pebird says:

      I wonder if some of Japan’s power elite reluctance is based on avoiding a shift in global monetary processes that have been in place for some time.

      As long as Japan remained an exporting country, Yen bond sales were effectively sterilized by their current account surplus.  So the Japanese public could hold Japanese debt and the BOJ could buy US debt.

      I don’t think it is a coincidence that Japan entered its long economic troubles just when first the Asian Tigers then China started to ramp up production of components and finished consumer goods.  Japan’s asset boom occurred just as their manufacturing dominance slipped away.  After their crash, the Japanese economy moved into a start-stop public spending mode, waiting for global demand to grow sufficient enough to bring back the good old days of large curent account surplus.  Financially, they continued their purchase of US debt, and internal saving was large enough to purchase Japaese debt.  But global demand could not rebound high enough for Japan now that China is the world’s workshop.

      Despite failing to reform their financial sector, the Japanese public was fortunate to have their postal banks, basically a public saving service, which the private sector has been trying to “reform”‘ that is, eliminate for quite a while.

      Now that there is a crisis, Japan not only has excess real capacity internally that can be brought to bear without inflationary pressures, but they also happen to have close to $900 billion in US debt that can be used to finance external resources (for those who don’t want Yen).

      Now that exports are down in Japan, the normal global circulation of debt has been disrupted; Japan no longer has the excess dollars to continue the purchasing US debt.  And savings will drop, so the public will be purchasing less Japanese debt.  Hence, the idea to have the BOJ directly purchase Japanese debt.  

      Ironically, when The ECB was “forced” to do this to save European banks it was accepted.  But when it is proposed to save the public after a series of real crises, well we have to consider long-term inflation rates and the bond market, don’t we?

    6. Benedict@Large says:

      My head is beginning to hurt again. High-powered money? As opposed to what? Low-powered money?

      Isn’t the claim that there is something different that makes money “high-powered” simply a claim that there is a liquidity constraint on federal bonds? If so, what is it? That the bond holder might actually have to convert it for SOME items he/she might want to purchase? So what? And even if that were a constraint, it’s not one that is IMPOSED upon the bond holder, but rather one that is SELECTED by the bond holder. In other words, whatever constraint there is, it’s only there because the bond holder wasn’t planning to spend the money anyways. And that’s no constraint at all.

      Am I missing something?

    7. Max says:

      Ralph, if there is any surplus of bank reserves, the overnight interest rate will be the interest paid on reserves. So this has implications for the implementation of monetary policy, but nothing more.

      There is actually no way for the government to commit to a 0% interest rate forever, even if it wanted to. The government always has the power to set the interest rate – whether the debt is in the form of bonds or money.

    8. Max says:

      Or in other words, “paying off the debt by printing money” is functionally meaningless. It may have a political/ideological meaning, but it has no economic significance. The only way to eliminate the debt is to run surpluses. You can imagine a reverse helicopter drop where the government taxes away everyone’s money. That would solve the debt non-problem but create some new problems!

    9. MacroStrategy Edge says:

      Bill:

      Doesn’t the BoJ (or any central bank in a sovereign currency nation) always have to create the money (reserves) that is eventually collected from the private sector as tax revenues or receipts from government bond sales?

      In other words, the T and the delta B can only come from delta H.

      Or in plain language, if I understand this correctly, the private sector can only, as a whole, get the money it pays for taxes and bonds by selling products, labor, or assets to the government. Otherwise it just runs down its existing stock of government created money.

      It sounds like the BoJ and Japanese policy makers do not realize the BoJ always has to create the money that gets collected as taxes or bond sales. Of course, banks create money deposits when they make loans or buy assets, but this bank created money generally cannot be a net financial asset of the private sector. If you take out a loan to pay your taxes, you still have to pay back the loan with money acquired from other activities.

      Or maybe I am missing something here.

    10. MamMoTh says:

      Inflation is caused by aggregate demand growing faster than real output capacity.

      Which can happen (and does happen) before full-employment, especially if you define it as 2% unemployment.

      But the assertion that the private placement of debt reduces the inflation risk is totally fallacious.

      It is not fallacious. You have your logic backwards. People spend money not bonds.
      The lower real interest rates are, the bigger the demand for credit will be, all other things equal.

    11. Neil, I think you are very bold to claim that interest rate cuts don’t raise demand. Granted that rates have been cut like never before in the last two years and this still has not raised demand as much as we would have liked. But we are recovering from a MASSIVE shock to the system: the credit crunch.

      Max, I don’t agree that the government cannot “commit to a 0% interest rate forever”. Indeed you yourself seem to admit that a permanent 0% rate is possible when you say that “The government always has the power to set interest rates”. Plus Warren Mosler favours a permanent 0% policy. See item No. 3 under the heading “Proposals for the Federal Reserve” here:

      http://www.huffingtonpost.com/warren-mosler/proposals-for-the-banking_b_432105.html

      “It may have a political/ideological meaning, but it has no economic significance.” I agree that there is a huge amount of politics, ideology and psychology involved here. To illustrate, I think it would be perfectly possible to do a “Mike Norman” and pay off the entire debt in two or three years, and the strictly economic effects (e.g. the effect on real living standards) would be around zero. However, the economic conservatives would jump up and down screaming “inflation”, and screaming it much louder than they’ve ever screamed it before. And that would be a big political or psychological problem.

      “The only way to eliminate the debt is to run surpluses.” That is true if national debt and high powered money (HPM) are counted as the same thing (and you could argue that they should be, as both appear on the liability side of central banks’ balance sheets). But if HPM is not officially classified as “debt”, then creating HPM and buying back debt WILL reduce the debt.

    12. Ramanan says:

      Further to Anon’s point …

      These debt sales do not “finance” government net spending – they are a monetary operation aimed at interest-rate maintenance. So M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. It is this result that leads to the conclusion that that deficits increase net financial assets in the non-government sector.

      Assuming non-banks buy all the G-Secs, M1 doesn’t rise than between the events (purchases of G-Secs followed by Government spending)… It is this result that leads to the conclusion noted above.

    13. Ramanan says:

      To remove confusions … instead of adding …

      “M1 doesn’t rise than between the events (purchases of G-Secs followed by Government spending)”

      should read:

      M1 doesn’t rise before and after the events, where events are defined as (purchases of G-Secs following by Government spending)

    14. Neil Wilson says:

      “People spend money not bonds.”

      People don’t necessarily spend money either – it can be saved, and as has been shown countless times bonds are generally held by institutions as hedges against their liabilities. There is never a time when the system chokes off spending because bonds have stopped it.

      “The lower real interest rates are, the bigger the demand for credit will be, all other things equal.”

      That assumes infinite capacity to repay. Even if interest rates are zero and you are giving money away there is a limit imposed by the capacity of the borrower to repay the principal. That always depends upon the decision makers view of an income stream and the value of the security and the borrowers view of the income stream and the risk cost in terms of security.

      I don’t see interest rates as reducing the demand for money – at least not directly. The total cost of repayments is a function of demand for money and that is largely independent of interest rates, but linked to the confidence in the market and no doubt lots of other things.

      In aggregate interest rates simply move money from borrowers to savers.

    15. Ramanan says:

      I am suspicious of the claims that there is no interest rate elasticity for the demand for loans. While it is true, – as Keynesians may argue – income effects are more important, it does not mean that interest rates are irrelevant.

      A 30y mortgage on a loan of $100,000 at 4.5% implies a monthly payment of $507 and a 9% rate implies $805 – a 59% increase!

      Even if regulation is tight, a rise in borrowing – high enough causing the private sector as a whole to deficit spend may lead to a huge increase in demand and its difficult for government to tighten fiscal policy and fine tune this, given that the private sector is already in deficit.

      Plus interest rates reduce creditworthiness. Creditworthiness is not independent of interest rates. A high interest rate means more burden to pay the debt and hence more risk.

    16. Andrew says:

      If interest rates were zero percent. I’m fairly sure I would borrow as much as I can get my hands on. I wouldn’t worry much about paying it back. Isn’t this what Japanese housewives do? They borrow 100x their deposit in forex accounts and buy the Aussie dollar at 4.5%. Then the hedge funds and banks churn the forex market to try and get the money off the wee ladies…..What a world we live in!

    17. MamMoTh says:

      Even if interest rates are zero and you are giving money away there is a limit imposed by the capacity of the borrower to repay the principal.

      Sure, but doesn’t the capacity of the borrower to repay the loan decrease when the real interest rate increases, ALL other things equal? Of course it does. That’s why housing bubbles end with a hike of the interest rate.

    18. bill says:

      Dear anon (at 2011/04/04 at 22:48) and the following discussion

      The self-imposed (voluntary) constraints that governments place on themselves give only the chimera of a financial constraint. The debt-issuance does not “fund” the public spending even with these constraints. The government borrows the funds it has spent no matter what institutional arrangements you might consider to be constraining. The voluntary constraints are political in nature.

      The easiest way to see that is to ask whether the US federal reserve (which is unambiguously part of the consolidated government sector) is financially constrained when it adds reserves to the banking system. What do you think would happen if the Treasury spent $USx and the bond tender didn’t raise the same amount. Would the cheques bounce? Not in a million years.

      Macrostrategy Edge (at 2011/04/05 at 4:17) has the correct understanding – the dollars have to come from government spending no matter what images are erected by these voluntary constraints – net financial assets in the non-government sector have to come from government (central bank and treasury) spending.

      So while you can lecture me about the order in which I present the discussion – thank you – it is crystal clear – governments borrow back their own spending. Logic tells us which way the causality goes!

      As to whether I cut and pasted the Krugman response – in part I did but rewrote the section. In the week following my “letter” to Paul Krugman I received more than 50 E-mails which showed that the correspondents still were struggling with the same material and same points. So repetition is warranted – especially as I gather new readers each week.

      best wishes
      bill

      Mar

    19. bill says:

      Dear Dan (at 2011/04/04 at 23:58)

      I do not agree with anon on that point as I explain below.

      I have written millions of words “constructing the deficit/debt debate”. I have written specific blogs about “why we have the rules we have”. I cannot be succinct as you demand and repeat these blogs over and again. In this blog I provided links to a long account of why there are voluntary rules. There are many blogs where I have examined that question – logically, politically and historically.

      Perhaps you need to do some more reading before stating that I have not paid attention to these issues.

      best wishes
      bill

    20. bill says:

      Dear Benedict@Large (at 2011/04/05 at 2:08)

      Your head is hurting because I used the term:

      High-powered money? As opposed to what? Low-powered money?

      The term is a vestige from the money multiplier literature (given I was talking about that framework) and refers – in that framework – to the fact that a $1 of base money multiplies to a larger volume of broad money – hence it is high-powered.

      Once you realise that the money multiplier is bunk then the term does not have that meaning.

      High-powered money = base money created by central banks.

      best wishes
      bill

    21. Dan says:

      Bill,

      My intention was not to offend just offer an opinion.

    22. Max says:

      “I don’t agree that the government cannot “commit to a 0% interest rate forever”. Indeed you yourself seem to admit that a permanent 0% rate is possible when you say that “The government always has the power to set interest rates”.”

      There is no irreversible way to set the rate to 0. Any “permanent” setting can be changed.

      Anyway, the main point is that “paying off the debt with money” doesn’t imply anything about monetary policy. That’s a seperate issue.

    23. anon says:

      Bill,

      Yes, this is old territory. But I don’t think I’m lecturing. My aim is to shed light incrementally. And it has worked, because you have changed some of your language over the past year.

      With regard to your response here, the use of reserves has nothing to do with logical causality – in the context of the existing institutional configuration.

      The government borrows and deposits the money in its account at the central bank. When it does so, that has the immediate effect of draining reserves from the banking system.

      It is the central bank’s role to calibrate that effective reserve drain. It does so by exchanging reserves for assets. That’s a question of degree. Over time, there is still a cumulative net inflow of deposits into the government’s account. That’s a fact because the account must be kept positive under existing institutional design. And the government then spends from that account. And perhaps when that happens the CB calibrates in the other direction as appropriate, with a reverse exchange of assets for reserves. The process goes on continuously. It is an ongoing calibration process that the CB undertakes, managing a cumulative net inflow into the government’s account at the central bank, such that its account will always be positive. That is called cash management. The government is managing its cash, acting as a currency user, in the context of the existing institutional configuration.

      The point is that there is nothing to demonstrate that the government borrows after it spends under such an institutional configuration. If anything, as described, it works the opposite way.

      That is the institutional reality – as opposed to the configuration that might result operationally if in fact the central bank was “unambiguously part of the consolidated government sector” at the level of actual institutional composition and integration, which it is not.

      If this current institutional configuration fails, emergency measures will no doubt supersede it to ensure that cheques don’t bounce.

      But that is secondary to the point, which is that the existing institutional system is not designed for the purpose of failure. And it is different than the emergency system that would supersede it in the event of failure.

      And it might be helpful to clarify these differences in the exposition of the MMT story. That is all I mean to say.

    24. Vassilis Serafimakis says:

      @MamMoTh:

      “The lower real interest rates are, the bigger the demand for credit will be, all other things equal.”

      That is true in the real world but what about the world of economics? If demand for M increases significantly (whatever M might be – wool shirts, jet skis, collateralised debt obligations), shouldn’t the price of M at some point rise? Assuming a finite quantity of M, I mean.

      Now, as I recall from my economics books, the ‘price’ of borrowed money is the interest one pays for it. Why aren’t interest rates ‘automatically’ rising when demand for money rises? I’m confused.

    25. Alan Dunn says:

      With the way unemployment is measured you would not be operating anywhere near full employment with an unemployment rate of 0% let alone 2%.

      After all, there are 168 hrs in a week and yet the ILO require just one hour in the week of the survey to class someone as employed.

      People might also want to pay some attention to income effects rather than solely focus upon the interest rate itself.

      As an example the current mortgage rate in Australia is less than 10% compared to around 18% or so in the early 1990′a.

      However, the cost of buying a house back then was much cheaper in terms of the percentage of a persons wage required to service the loan.

      Hence, people’s capacity to pay has actually decreased while the rate of interest has indeed falling.

      Well done on the ABC radio this morning as well Bill with your discussion on Work for the Dole.

    26. Andy says:

      How in the name of Gordon’s does he find the time to put this stuff together daily, answer questions arising and hold down a day job? Bill. Don’t waste time answering that.

    27. Neil Wilson says:

      “The point is that there is nothing to demonstrate that the government borrows after it spends under such an institutional configuration”

      The simple logic of a fiat system shows that spending comes first. There is simply nothing to borrow in period zero. The currency issuer must make the first journal entry.

      However after that spending is a cycle – a circle if you like – and it is valid to view it from any point on that circle. Each point gives you a different view of the operations and a different mindset.

      Most importantly it is not *incorrect* to view government spending as coming first. To say that a government can spend and then people save what is left over with the government is an entirely accurate description of the current system. And simply looking at it that way gives you a different insight into what a government is capable of doing safely.

    28. Neil Wilson says:

      “Sure, but doesn’t the capacity of the borrower to repay the loan decrease when the real interest rate increases, ALL other things equal? Of course it does. That’s why housing bubbles end with a hike of the interest rate.”

      You may believe that, but I’ve seen little evidence to validate that view. The credit cycle ends when it ends – monetary policy of all shades appears to have very little effect on the course of the credit cycle.

      Essentially ALL other things aren’t equal and pretending they are just gives you the wrong view.

    29. Neil Wilson says:

      “I’m fairly sure I would borrow as much as I can get my hands on.”

      I’m sure you would. However to do that you’d have to persuade somebody to lend it to you – and that is where the constraints kick in.

    30. Vassilis Serafimakis says:

      @anon

      “The government borrows and deposits the [borrowed] money in its account at the central bank. … And the government then spends from that account. … That is called cash management. The government is managing its cash, acting as a currency user, in the context of the existing institutional configuration.”

      I don’t understand. This might be indeed how the accounting entries are working out but are you saying that when the balance of the government’s account at the central bank drops down to zero, the government can no longer spend?

      “There is nothing to demonstrate that the government borrows after it spends under such an institutional configuration. If anything, as described, it works the opposite way.”

      But this is only the (second) half of the ‘story’. Before the government spends, let alone borrow, and in order to maintain a “positive balance” in its accounts, it can, can’t it?, very well credit those accounts – through the mysterious and extremely complex mechanism described recently by Ben “Blubbermouth” Bernanke (“We just credit ‘em electronically”).

      And your “institutional configuration” remains intact throughout. What am I missing?

    31. anon says:

      “There is simply nothing to borrow in period zero.”

      The regress argument doesn’t work much better than the going concern argument.

      Suppose the required reserve balance is zero in the beginning.

      Suppose the government’s desired operating balance at the central bank is X in the beginning.

      Then the government borrows X.

      The reserve impact is (X).

      There is an immediate daylight overdraft position with the central bank as a result.

      The central bank then buys X in assets to eliminate the overdraft.

      Both the overdraft and the asset purchase fall under the broad category of “spending” for the consolidated entity. The overdraft temporarily funds the reserve shortage, and the asset purchase returns reserves to normal.

      The logic is that the central bank is responding to the government action of borrowing, in sequence.

      Borrowing is first.

    32. bill says:

      Dear Anon

      Where did the X net assets come from?

      Borrowing cannot come first in a fiat monetary system.

      best wishes
      bill

    33. Andrew says:

      There are a lot of people of the “Small Government” ideology desperate to believe Governments fund spending by borrowing. To cede this point would be a hard blow.

      Don’t expect them to accept inconvenient facts lightly.

    34. anon says:

      Bill,

      In the beginning, net assets are not required.

      Borrowing creates a reserve debit – a negative reserve position – as I described.

      The (automatic) overdraft is the first response – and it is a response – to that borrowing.

      A positive reserve stock is not required for the initial borrowing.

    35. Neil Wilson says:

      “A positive reserve stock is not required for the initial borrowing.”

      The central bank is owned by the government. You can’t journal between them and create anything. On the consolidated balance sheet it disappears.

      The first journal involving the non-government sector is a spend transaction.

    36. Ramanan says:

      The simple logic of a fiat system shows that spending comes first. There is simply nothing to borrow in period zero. The currency issuer must make the first journal entry.

      Well that comes under the assumption that there is an institution called Government before people start eating.

      If you want to make a textbook model where you begin with all sectors, then you are free to assume that the government starts with a overdraft.

      An example. Let us say that Australians discover a new island nearby and call it New Australia. Now to begin with they start transacting in Australian dollars and a Government and a central bank are formed and banks are allowed to create currency called “New Australian Dollar” and economists forbid the Government from taking an overdraft at the central bank and prevent direct purchases of Government securities by the Central Bank of New Australia.

      For the New Australian Government to spend, it has to auction. It is not necessary for the proceeds to be deposited at the New Australian Treasury’s account at the Central Bank of New Australia. It can be deposited in a bank. Initially banks may purchase all the debt and credit the Treasury’s deposit account. Non-financial institutions can also participate: They sell AUD assets to private banks and these banks credit their NAD accounts. The investors use the funds to purchase New Australian Treasury securities.

      After some time, the Treasury is provided with an account at the central bank and reserves change due to the Treasury’s actions.

      At no point in the above hypothetical scenario did government spend first and tax later!

      Why this roundabout route – to point out intrinsic fallacies in the arguments such as “Bond issuance IS not a borrowing operation”, especially when the example of the Fed/Treasury is used to defend the position.

      Now I understand that the phrase “self-imposed constraints” is used, but then the next day one sees a statement saying its wrong to say that the government borrows etc.

      Why so much effort debating this ? It’s a feedback.

      You explain to the other person that in spite of the fact that the Treasury needs to borrow, it creates financial assets in the process. Deficit spending units create financial assets for the other sectors.

      Even in other institutional setups, a deficit of the government sector is a surplus of the private sector. Government deficits increase the net worth of the private sector even if one talks of “pre-1971″. But then there one sees the argument …government borrows first and spends later etc in those setups.. Something of that sort.

      PS:

      I know the PUNCH.

    37. anon says:

      “The central bank is owned by the government.”

      You persistently avoid/miss the point of the debate.

      The point is to describe current institutional arrangements, as opposed to imagined ones.

    38. MamMoTh says:

      You may believe that, but I’ve seen little evidence to validate that view.

      Of course I do believe that an increase in the real interest rate decreases the capacity of the borrower to repay a loan, ALL other things equal (income, collateral, asset price, regulations, etc.). This is just logic, no need for evidence.

      Credit booms end when people start being unable to make their payments because their capacity to repay the loan decreased, for instance because of an interest rate hike like the housing bubble in the US and the one in the UK in the 80s.

    39. Neil Wilson says:

      “The point is to describe current institutional arrangements, as opposed to imagined ones”

      It’s not me that’s imagining transactions. The central bank is owned by the government today. Therefore if you alter the equity liabilities of the central bank you alter the government’s position overall.

      Trying to pretend otherwise is nothing more than accounting fiction.

      What you have demonstrated very clearly is that the government can borrow from itself – as can anybody else.

    40. Neil Wilson says:

      “This is just logic, no need for evidence.”

      Except that the logic is flawed at the macro level since one person’s interest is another person’s income – even more so in fixed rate loan environments.

      “for instance because of an interest rate hike like the housing bubble in the US and the one in the UK in the 80s.”

      As I said the evidence of causality doesn’t seem to be there. Credit booms end when the ponzi stack of cards falls down, and that isn’t necessarily interest rates doing. It seems to be more to do with a reduction in lending standards as people mine an increasingly bare lending landscape.

    41. MamMoTh says:

      Except that the logic is flawed at the macro level since one person’s interest is another person’s income – even more so in fixed rate loan environments.

      Your logic is flawed. Borrowers do care about how much it will cost them to repay the loan. Lenders about the likelihood of borrowers defaulting. They are decisions at the micro level.

      Do you know anyone who would borrow the same amount from a bank if real interest rate was 0.25% or 100% ALL other things equal?
      Do you know any bank that would lend the same amount to a customer if real interest rate was 0.25% or 100% ALL other things equal?

      Credit booms end when the ponzi stack of cards falls down

      And when does it happen? When some borrowers become unable to make their payments, which can trigger a chain reaction.
      Why do the first borrowers become unable to meet their payments? Because their capacity to make them is decreased, for instance, because of a hike in the interest rate. As Ramanan mentioned, even a small hike compounded over 30 years will make a big difference in the monthly payment.

    42. Tom Hickey says:

      We already had this discussion at Warren’s place in “Marshall’s latest” some time ago. Is there something new to add?

    43. A negative reserve position–a reserve debit–is a loan from the govt sector. You can’t have a negative reserve position unless you are borrowing. You don’t get a negative balance in your checking account unless you get a loan from your bank. An overdraft is a loan. So, in order for the non-govt sector to buy govt bonds or pay taxes, the govt sector must either run a deficit or lend to the non-govt sector.

      I explained this last year at Naked Capitalism. The pdf version is here–http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1723198

      “This all leads me to the often noted MMT point that “spending comes before tax revenues are received or bond sales.” If one expands this a bit to include loans from the Fed, then this statement is absolutely correct in terms of the operational realities of the monetary system. That is, according to both the tactical and accounting logics, taxes credited to the Treasury’s account and the settlement of Treasury bond auctions can only occur via bank reserve accounts, while the original source of banks’ balances in their reserve accounts can only be previous government deficits (which are net credits reserve accounts) or loans from the Fed (repos, loans, purchases of private securities, or overdrafts—note that an outright purchase of a Treasury security by the Fed to add reserve balances requires a previous government deficit). Therefore, it very much is the operational reality that for taxes to be paid or bonds to be settled, there has to have been previous government spending or loans from the Fed to the non-government sector, and this is true whether or not the Fed is legally prohibited from providing overdrafts.

      However, the statement that “deficits or Fed lending logically precede tax payments and bond sales” should not be interpreted as “MMT’ers think there is no legal obligation that the Treasury have balances in its account before it spends or are otherwise ignoring the existing law prohibiting Fed overdrafts for the Treasury.” As I noted above, it is clear that the Fed cannot legally provide overdrafts to the Treasury, and every MMT’er does in fact understand this—the key is to understand what “deficits or Fed lending logically precede tax payments and bond sales” does and does not mean. That is, when MMT’ers say the latter, they are effectively saying “deficits or Fed loans logically precede taxation and bond sales as an operational reality of the monetary system” (the general case), and this and the statement “the Treasury must have positive balances in its account prior to spending under current law” (the specific case) are in fact not mutually exclusive. Both can be and are true—the government can and does require itself through its own self-imposed constraint to obtain credits to its own account at the Fed that were created via previous deficits or Fed lending before it spends again.”

    44. Ramanan says:

      Scott,

      So, in order for the non-govt sector to buy govt bonds or pay taxes, the govt sector must either run a deficit or lend to the non-govt sector.

      The federal government and monetary authority together can either be net borrowers or net lenders (these two cases are exhaustive).

      Why did I say this ? Because the things you have written in para 4 of your comment, can be said identically for Greece. (No, I am not arguing US=Greece).

      When the Greek Treasury raises funds through auctions, the funds movement to the Treasury’s account is the almost identical as the fund movement to the US Treasury’s account in the analogous case for the US.

      To the extent foreigners are not involved, the ECB is not involved in the settlement process. Its only the Bank of Greece which is neutralizing the effects of reserve changes.

      But that doesn’t make the Greek government an issuer of €s.

      What happens in case foreign banks and non-banks are involved ? – (just Euro residents for simplicity):

      Banks: Lets say a German bank buys Greek debt. i.e.,

      - the German bank submits its auctions and assuming its successful,
      - its reserves are debited by Bundesbank,
      - Bank of Greece debits Bundesbank’s account at the former’s books (to be settled through the ECB at the end of the day, but there is no limit – NCBs have unlimited/uncollateralized overdrafts at the ECB) and
      - the Bank of Greece credits the Greek Treasury’s account.

      Non-banks: Similar story with the addition being that a German bank debiting the account of the German institution buying the debt.

      So the whole story is analogous to the case of the Euro Zone.

      So whats the problem with the Euro Zone – its because the balance of payments problems of Greece and other countries make it increasingly expensive for the nations to raise money because the government debt keeps rising and foreigners within the Euro Zone have to be attracted plus there is no option of depreciation.

      Again, it doesn’t make the Greek government an issuer of Euros, even though it has an account at the NCB and spends by creating settlement balances.

    45. Some Guy says:

      Nothing to add but that this has nothing particularly to do with fiat money. The argument is: If Somebody asks You for Stuff that You cannot create, and You give it to him, then You must have had the Stuff to begin with. If Somebody is the only source of that Stuff, then You must have gotten the Stuff from him, directly or indirectly, earlier.

      Ramanan: The initial New Australian spending was the recognition of pre-existing Australian dollars as New Australian dollars. Just as the USA first spent by recognizing pre-existing Spanish silver dollars. Spending (from Somebody’s creation of Stuff) must come first, as the Somebody/You/Stuff argument shows.

    46. Suggesting that “because the non-govt sector in a country must either receive govt spending or borrow from the cb or Tsy before it can spend therefore that country’s govt is a sovereign currency issuer” is not necessarily true. It doesn’t go both ways. That is, “if A (sovereign currency issuer), then B (non-govt sector can only pay taxes or buy bonds via previous deficits or loans from cb or tsy),” doesn’t necessarily mean that “if B then A” is also true. That’s a very basic logical fallacy. Even though “if A, then B” might be true, there can still be many cases where B is true but A is not–again, Logic 101.

      At any rate, I was largely responding to something someone else had said—the suggestion that an overdraft wasn’t debt or wasn’t effectively the creation of balances.

    47. “At any rate, I was largely responding to something someone else had said—the suggestion that an overdraft wasn’t debt or wasn’t effectively the creation of balances.”

      That is, assuming I interpreted correctly. Perhaps not.

    48. Andrew says:

      Just playing with alternative views here. The Government has the authority vested in it by society. The private sector does not have this authority, because (for good reason) we don’t trust other members of our society to make decisions that affect us without public accountability.

      There are idle workers standing by. At the behest of society Government can instruct these workers to perform useful work. They can instruct others members of society to provide food, clothing etc from their stocks and spare capacity. Whatever is considered a fair exchange of goods for services provided.

      The facts are clear. The unemployed do not have the organizational ability and the private sector does not have the authority to put the unemployed to work.

      You can make as many complicated and spurious arguments you like about the chicken and the egg. Where the fuck does money really come into it. If the Governments wants it done and it has the resources, It orders it done. Money or no money.

    49. Alan Dunn says:

      It’s amazing the lengths an otherwise intelligent neo-liberal will go to in defending what they ultimately know to be false.

    50. Anders says:

      Re: arguing that spending/lending by the govt/CB is logically prior to tax and bond sales – the argument from settlement via reserve balances certain works, but isn’t it much simpler to point out that cash itself is obviously a claim upon the govt? How else can this twenty in my pocket have come from if not from past govt spending?

      I’m not sure what’s wrong with this broader argument.

      Also – Ramanan’s modus tollens notwithstanding – doesn’t this argument have little to do with current monetary sovereignty? The twenty in my pocket implies that it was once spent by an authority which was once a currency issuer, even if it may no longer be such (eg Greece).

    51. anon says:

      Scott,
      That’s a good explanation. A few observations:
      - there has been much criticism over the past year from various quarters as to why those interested in this question are so obsessed with splitting hairs and nit picking on something that is so obvious to MMT’ers. I’d just point out that a degree of thoughtfulness and care seems to be required in actually answering the question effectively, and I see no corresponding complaints about that (thankfully).
      - this question has been asked consistently as it pertains to the logical causality of spending and borrowing in the context of the existing institutional configuration, which includes separate treasury and central bank functions. It’s not unreasonable to think of the question therefore as being directed at the treasury function per se, with central bank reserve management issues set to one side. As far as the treasury function on its own is concerned, which focuses on treasury’s deposit account with the central bank, it’s not so evident that spending logically precedes borrowing. The question has focused on that account, as opposed to the consolidated view, where the account disappears in effect.
      - as far as the consolidated view is concerned, one idea is fairly prominent – that the central bank provides the reserves to accommodate net settlement of government borrowing from the private sector, whether those reserves already exist from previous deficits or they are provided anew as in a zero reserve requirement system. This accommodation is classified more generally as spending, along with government budget outlays, since reserves are produced in both cases. I have no problem with those facts. However, the logical causation of central bank accommodation might still be examined. On the one hand, reserve “spending” can be required in order to facilitate bond settlements, which suggests that spending is logically prior. On the other hand, there would be no bond settlement or reserve requirement in this case were it not for the borrowing, which might suggest the borrowing is what leads to and is logically prior to the spending (of reserves) in this case. If a bond auction were to fail, there would be no crediting of the government account at the central bank, and no requirement for reserves in settlement due to government borrowing per se. The accounting entry for the overdraft won’t be made if there hasn’t been a crediting of funds to the government account. It won’t be made unless borrowing has taken place successfully. That might suggest that borrowing logically precedes spending (overdraft reserves) in this case. I don’t see where this logic is wrong when one is examining this issue at the level of reserve settlement. Although the consolidated perspective is secondary to the original question, it’s not clear to me why this second interpretation of consolidation is particularly erroneous.
      - bTW, I have no problem with the idea that overdrafts constitute debt and require reserves. If there were a difference, it wouldn’t be terribly critical to this discussion.

    52. Oliver says:

      On the one hand, reserve “spending” can be required in order to facilitate bond settlements, which suggests that spending is logically prior. On the other hand, there would be no bond settlement or reserve requirement in this case were it not for the borrowing, which might suggest the borrowing is what leads to and is logically prior to the spending (of reserves) in this case.

      What MMT says, I believe, is that, in the purely logically deduced, general case (as opposed to the historically grown, fudged, specific case), there could not have been a bond sale to accompany the initial reserve spending. Currency sovereignty logically precedes borrowing even though the provision to borrow may precede the current sovereign. That’s precisely the point and also the reason why MMT logic demands there must be a hierarchy, the top of which is occupied by the sovereign currency issuer, which in most cases (though not the EU e.g.) is congruent with the nation state. It is a question of ‘who is currently in charge of making the rules’, and not ‘which other legal entity preceded our current sovereign’. A sovereign can inherit and take over the rules from a former setup or nation state out of sheer laziness or convenience or out of a false belief that TINA, but that does not mean it cannot change the rules or at least conveniently bend them to its own advantage. And it also doesn’t mean that some other legal entity can’t take over in future. It is this current legal hierarchy which the MMT argument logically is deduced from. The critique always seems to be from an historical perspective which may be at odds with the general case, but does not reduce its potential.

    53. Ramanan says:

      “Spending” is dangerous terminology. National accountants (as per SNA 2008) use the phrase “expenditure”.

      The Fed’s asset purchase program (“QE”) cannot be described as saying that the Fed “spent” trillions in purchasing government bonds, MBSs etc.

      Spending is always on goods and services. Its difficult to describe interest payments as spending, so expenditures is the better phrase.

      There are terms used such as “off balance sheet deficit spending” to describe FX purchases by the central bank which is neither off-balance sheet, neither deficit spending and not spending either. Plus neither does fx purchases increase the private sector surplus (in the accounting period in question, or increase the government deficit) and/or net worth of the private sector.

      Similarly neither does purchases of private sector securities by the government count as expenditures and does not increase the deficit even though the purchase creates reserves at the time of transfer of funds.

      I have raised these in some comments and I believe they are all related.

    54. anon says:

      R.,

      You’re correct on the accounting terminology, of course. MMT tends to lump it all in together at times, in the abstract as per functional consolidation, where reserves are created. I did the same out of consideration for that approach.

    55. Scott Fullwiler says:

      Anon,

      No problem with any of that. In terms of the real-world case where the Tsy must replenish its account, as I think you already know, I then go to whether or not the Tsy could issue its debt at roughly the cb’s target rate. If so, then the distinction between the more general MMT case and the real world isn’t economically significant in my view (in terms of how it affects the Tsy, that is; it may be significant in other ways, which is your point, I think).

      Ramanan @0:57 . . . that sounds good to me.

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