Deficit spending 101 – Part 2

This is the second blog in the series that I am writing to help explain why we should not fear deficits. In this blog we clear up some of the myths that surround the so-called “financing” of budget deficits. In particular, I address the myth that deficits are inflationary and/or increase the borrowing requirements of government. The important conclusion is that the Federal government is not financially constrained and can spend as much as it chooses up to the limit of what is offered for sale. There is not inevitability that this spending will be inflationary and it does not necessarily require any increase in government debt.

The first thing to recall from Part 1 is that spending by private citizens is constrained by the sources of available funds, including income from all sources, asset sales and borrowings from external parties. Federal government spending, however, is largely facilitated by the government issuing cheques drawn on the central bank. The arrangements the government has with its central bank to account for this are largely irrelevant. When the recipients of the cheques (sellers of goods and services to the government) deposit the cheques in their bank, the cheques clear through the central banks clearing balances (reserves), and credit entries appear in accounts throughout the commercial banking system. In other words, government spends simply by crediting a private sector bank account at the central bank. Operationally, this process is independent of any prior revenue, including taxing and borrowing. Nor does the account crediting in any way reduce or otherwise diminish any government asset or government’s ability to further spend.

Alternatively, when taxation is paid by private sector cheques (or bank transfers) that are drawn on private accounts in the member banks, the central bank debits a private sector bank account. No real resources are transferred to government. Nor is government’s ability to spend augmented by the debiting of private bank accounts.

In general, mainstream economics errs by blurring the differences between private household budgets and the government budget. Statements such as this one from reputed economist Robert Barro that “we can think of the government’s saving and dissaving just as we thought of households’ saving and dissaving” are plain wrong.

Mainstream economics uses the government budget constraint framework (GBC) to analyse three alleged forms of public finance: (1) Raising taxes; (2) Selling interest-bearing government debt to the private sector (bonds); and (3) Issuing non-interest bearing high powered money (money creation). Various scenarios are constructed to show that either deficits are inflationary if financed by high-powered money (debt monetisation), or squeeze private sector spending if financed by debt issue. While in reality the GBC is just an ex post accounting identity, orthodox economics claims it to be an ex ante financial constraint on government spending.

The GBC framework leads students to believe that unless the government wants to print money and cause inflation it has to raise taxes or sell bonds to get money in order to spend. People have the erroneous understanding that taxation and bond sales provide money for the government which they use to spend. So if the government increases its deficit (spending more than taxing) then it must be increasing its debt holdings or “printing money”, both of which are deemed undesirable.

However the reality is far from this erroneous conception of the way the Federal government operates its budget. First, a household, uses the currency, and therefore must finance its spending beforehand, ex ante, whereas government, the issuer of the currency, necessarily must spend first (credit private bank accounts) before it can subsequently debit private accounts, should it so desire. The government is the source of the funds the private sector requires to pay its taxes and to net save (including the need to maintain transaction balances). Clearly the government is always solvent in terms of its own currency of issue.

Mainstream economics also misrepresents what it calls “money creation”. In the popular macroeconomics text, Olivier Blanchard (1997) says that government

can also do something that neither you nor I can do. It can, in effect, finance the deficit by creating money. The reason for using the phrase “in effect”, is that … governments do not create money; the central bank does. But with the central bank’s cooperation, the government can in effect finance itself by money creation. It can issue bonds and ask the central bank to buy them. The central bank then pays the government with money it creates, and the government in turn uses that money to finance the deficit. This process is called debt monetization.

This is what mainstream economists call “printing money”. However, it is an erroneous conception in terms of the monetary system. To monetise means to convert to money. Gold used to be monetised when the government issued new gold certificates to purchase gold. Monetising does occur when the central bank buys foreign currency. Purchasing foreign currency converts, or monetises, the foreign currency to the currency of issue. The central bank then offers federal government securities for sale, to offer the new dollars just added to the banking system a place to earn interest. This process is referred to as sterilisation. In a broad sense, a federal (fiat currency issuing) government’s debt is money, and deficit spending is the process of monetising whatever the government purchases.

It is actually rather obvious but all government spending involves money creation. But this is not the meaning of the concept of debt monetisation as it frequently enters discussions of monetary policy in economic text books and the broader public debate. Following Blanchard’s conception, debt monetisation is usually referred to as a process whereby the central bank buys government bonds directly from the treasury. In other words, the federal government borrows money from the central bank rather than the public. Debt monetisation is the process usually implied when a government is said to be printing money. Debt monetisation, all else equal, is said to increase the money supply and can lead to severe inflation.

However, fear of debt monetisation is unfounded, not only because the government doesn’t need money in order to spend but also because the central bank does not have the option to monetise any of the outstanding government debt or newly issued government debt. In Part 3 I will show that as long as the central bank has a mandate to maintain a target short-term interest rate, the size of its purchases and sales of government debt are not discretionary. The central bank’s lack of control over the quantity of reserves underscores the impossibility of debt monetisation. The central bank is unable to monetise the government debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to any support rate that it might have in place for excess reserves. We will consider this step-by-step in Part 3.

In summary, we conclude from the above analysis that governments spend (introduce net financial assets into the economy) by crediting bank accounts in addition to issuing cheques or tendering cash. Moreover, this spending is not revenue constrained. A currency-issuing government has no financial constraints on its spending, which is not the same thing as acknowledging self imposed (political) constraints.

Once we realise that government spending is not revenue-constrained then we have to analyse the functions of taxation in a different light. Taxation functions to promote offers from private individuals to government of goods and services in return for the necessary funds to extinguish the tax liabilities.

The orthodox conception is that taxation provides revenue to the government which it requires in order to spend. In fact, the reverse is the truth. Government spending provides revenue to the non-government sector which then allows them to extinguish their taxation liabilities. So the funds necessary to pay the tax liabilities are provided to the non-government sector by government spending. It follows that the imposition of the taxation liability creates a demand for the government currency in the non-government sector which allows the government to pursue its economic and social policy program.

This insight allows us to see another dimension of taxation which is lost in mainstream analysis. Given that the non-government sector requires fiat currency to pay its taxation liabilities, in the first instance, the imposition of taxes (without a concomitant injection of spending) by design creates unemployment (people seeking paid work) in the non-government sector. The unemployed or idle non-government resources can then be utilised through demand injections via government spending which amounts to a transfer of real goods and services from the non-government to the government sector. In turn, this transfer facilitates the government’s socio-economics program. While real resources are transferred from the non-government sector in the form of goods and services that are purchased by government, the motivation to supply these resources is sourced back to the need to acquire fiat currency to extinguish the tax liabilities.

Further, while real resources are transferred, the taxation provides no additional financial capacity to the government of issue. Conceptualising the relationship between the government and non-government sectors in this way makes it clear that it is government spending that provides the paid work which eliminates the unemployment created by the taxes.

So it is now possible to see why mass unemployment arises. It is the introduction of State Money (which we define as government taxing and spending) into a non-monetary economics that raises the spectre of involuntary unemployment. As a matter of accounting, for aggregate output to be sold, total spending must equal total income (whether actual income generated in production is fully spent or not each period). Involuntary unemployment is idle labour offered for sale with no buyers at current prices (wages). Unemployment occurs when the private sector, in aggregate, desires to earn the monetary unit of account through the offer of labour but doesn’t desire to spend all it earns, other things equal. As a result, involuntary inventory accumulation among sellers of goods and services translates into decreased output and employment. In this situation, nominal (or real) wage cuts per se do not clear the labour market, unless those cuts somehow eliminate the private sector desire to net save, and thereby increase spending.

So the purpose of State Money is to facilitate the movement of real goods and services from the non-government (largely private) sector to the government (public) domain. Government achieves this transfer by first levying a tax, which creates a notional demand for its currency of issue. To obtain funds needed to pay taxes and net save, non-government agents offer real goods and services for sale in exchange for the needed units of the currency. This includes, of-course, the offer of labour by the unemployed. The obvious conclusion is that unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.

This analysis also sets the limits on government spending. It is clear that government spending has to be sufficient to allow taxes to be paid. In addition, net government spending is required to meet the private desire to save (accumulate net financial assets). From the previous paragraph it is also clear that if the Government doesn’t spend enough to cover taxes and the non-government sector’s desire to save the manifestation of this deficiency will be unemployment. Keynesians have used the term demand-deficient unemployment. In our conception, the basis of this deficiency is at all times inadequate net government spending, given the private spending (saving) decisions in force at any particular time.

For a time, what may appear to be inadequate levels of net government spending can continue without rising unemployment. In these situations, as is evidenced in countries like the US and Australia over the last several years, GDP growth can be driven by an expansion in private debt. The problem with this strategy is that when the debt service levels reach some threshold percentage of income, the private sector will “run out of borrowing capacity” as incomes limit debt service. This tends to restructure their balance sheets to make them less precarious and as a consequence the aggregate demand from debt expansion slows and the economy falters. In this case, any fiscal drag (inadequate levels of net spending) begins to manifest as unemployment.

The point is that for a given tax structure, if people want to work but do not want to continue consuming (and going further into debt) at the previous rate, then the Government can increase spending and purchase goods and services and full employment is maintained. The alternative is unemployment and a recessed economy. It is difficult to imagine that an increasing deficit will be inflationary in a recessed economy because there are so many underutilised resources, both capital and labour.

Indeed, as I continually point out, the first thing that the Federal government should do is offer all the labour that no-one else wants a job and pay them a minimum wage with all the additional statutory entitlements. By definition, the unemployed have no “market price” because there is no demand for their labour. Offering to buy a service for which there is no price is not an inflationary act.

In Part 3, we consider the argument that deficits automatically drive up interest rates because the government borrowing squeezes available funds in the money markets. As you will guess … this is another neo-liberal myth which is designed to render government’s inactive.

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    17 Responses to Deficit spending 101 – Part 2

    1. Cameron says:

      OK Bill… you’re taking me along on the trip…I have to re-read the paragraphs a few times to get it.

      Bear with me though, the concepts are pretty far from what I was taught in high school :-)

      I have trouble understanding the part about (may I paraphrase?) “the private sector must acquire fiat currency as a way to extinguish it’s tax liability owed to the government”.

      I don’t really get this…it kind of implies that every person is born and business is created owing tax up front. Clearly our tax system works on productivity (after the fact)..you can’t pay till you’ve created anything…!

      or am I thinking too small?

    2. Chris Sutter says:

      Hi

      I’ve recently come across MMT and I think it is a very coherent and, importantly, useful theoretical framework. It is not based on un-proven, value-laden statements like “private business is always more efficient than government”.

      Now there is one question I have – if our government doesn’t need to “finance” spending like your or I do, why do we collect the GST? Why do we force businesses to spend hours filling out paperwork and threaten them if they make mistakes? Is it simply to create work for accountants and tax advisers? I studied accounting and briefly considered it as a career until it occurred to me how much time accountants spend doing tasks which, to me, seemed to offer little or no value to human existence. A lot of repeatedly pushing a rock up a hill just to watch it roll back down, or digging a hole and filling up it again, if you know what I mean…

    3. bill says:

      Dear Chris

      Good question. It is a hangover from the gold standard era – read on I have covered this topic in several different ways. Most recently in this blog – http://bilbo.economicoutlook.net/blog/?p=6891.

      The mainstream economics profession is still stuck in the gold standard and also have an ideological dislike for government activity – which means that having this “financing” constraint on government – that is, always talking about “taxpayer funds” is a convenient fiction to advance their value systems.

      But the reason we collect taxes is also because it is a functional way to reduce the private sector purchasing capacity to ensure that nominal spending growth doesn’t outstrip real capacity. I cover this angle in many places but this post might help – http://bilbo.economicoutlook.net/blog/?p=5762

      Hope that helps

      best wishes
      bill

    4. Chris Sutter says:

      Thanks Bill for your prompt response.
      I would say then that we should abolish Howard’s crowning “achievement” as the first opportunity in favor of a more simple taxation system. A system that helps less advantaged people to develop skills, own their own dwelling and contribute positively to the community. The current complex system just seems to create work for accountants, lawyers and tax advisers and provide ways for the rich to built mountains of paper wealth and drive up asset prices.

    5. Hugo Heden says:

      @Cameron

      This is a late reply and not likely to be correct, but I’ll give it a shot anyway — perhaps someone else will step in.

      Imagine a primitive economy using a barter system. The people together decides to issue currency (and run a socio-economic program etc). They would announce that taxes will be collected on all business — even non-monetary transactions.

      It would be extremely difficult (though perhaps possible) to make a life without having to pay taxes. You’d have to grow your own food etc. So saying that pretty much the whole private sector has tax liabilites owed to the government is probably a reasonable approximation.

      Cheers

    6. Andrew says:

      Could the reason for taxation be put in more simple terms?
      - It allows the government to contract the money supply to control inflation.
      - It allows the government a second form of wealth redistribution (in addition to its spending).

    7. Neil Wilson says:

      The reason for taxation is to provide friction on government spending so that it doesn’t get out of control and cause inflation.

      See http://www.3spoken.co.uk/2010/08/reason-for-taxation-and-what-deficit.html

    8. Andy says:

      Neil /Bill
      I would like to point out that you have just wiped out my entire understanding of macro-economics accumulated over 20 years.
      Thank you !

    9. bill says:

      Dear Andy (at 2010/09/09 at 15:10)

      I am very happy that I have done that!

      best wishes
      bill

    10. Frank says:

      I do not understand the relationship between this description and fractional reserve banking. If a commercial bank can synthesise money, and if a complex of commercial entities relies on this money to “grow” (eg: real estate developers with commercial bank accounts), and if the state authorises material repossession in the event of debt defaults (transfer of property rights), then the commercial banks become government by proxy, except that the money supply is driven by debt demand. It seems to me that as long as commercial banks can synthesise debt-money in this way, the mechanism above is hijacked.

    11. Frank says:

      Just to clarify: perhaps it might not have been initially so, but what motivates me to get out of bed and hunt the national tiddlywinks each day is that if I do not, the banks will eventually make me homeless, and I’m sure that this debt-repayment motivation is what is on the minds of most today. I think this is why people demand the national currency, not because they have to pay taxes, but because they have to pay the bank.

    12. Neil Wilson says:

      Frank,

      Why would the bank want your worthless tiddlywinks?

    13. Frank says:

      Neil,

      Ah yes, good point, why did I not think of that?! I appreciate your responding.

      ..but, please help me to understand further: is it not the case that the initial value may once have been supplied by the demands of taxation, but that now the banks are demanding the tiddlywinks for other reasons?, eg:
      - it helps them to issue yet more debt (tiddlywinks), so that they may reward themselves in profits
      - it helps to shift wealth in their direction (if everyone is consuming their tiddlywinks because they are more indebted)
      - defaults on debt slowly shift real wealth in the banks’ direction?

      I don’t make these statements above as heartfelt beliefs. I am with an open mind. Thank you.

    14. harumphington says:

      In your theoretical system, who decides what the tax rates are each year? Who decides what the budget is each year?

    15. ^gareth^ says:

      Hello, and thanks for this educational site. I am trying to understand MMT. Do I get this all correct? I am from the UK so am only familiar with the system here; is it different from the US?

      The way the UK government spends is by holding what is essentially an overdraft with the Bank of England. They have also a cash account, the “Consolidated Fund” from which departments spend money; money is moved here from the overdraft account every day to finance spending. Each day the Debt Management Agency (part of the UK Treasury) issues gilts or bills (and perhaps redeems also) to ensue that the overdraft finishes the day at exactly zero. So that is my understanding of the status quo.

      I don’t quite understand how the MMTers would change this: is it:

      a) That the government has no need to bring the overdraft back to zero each day. They can spend money, and if the overdraft gets big during a recession, so be it; this is effectively the central bank “financing” the government by allowing them to run an overdraft, or

      b) That the government need not debit the overdraft account each time it spends money /at all/. Because it owns the currency, and can do what it likes with it.

      Sorry for the newbie questions. ^gareth^

    16. bill says:

      Dear ^gareth^ (at 2010/10/10 at 0:42)

      Sorry for the delay in replying but the last week has been quite busy.

      You outlined the administrative arrangements between the UK Treasury and the BOE that are associated with public spending. The accounting gymnastics you detail are clearly just voluntary contrivances and obscure the fact that the government can spend whenever it wants. The personnel involved in all the debt-issuing, overdraft management etc could be more productively employed serving other public needs.

      Then you ask what Modern Monetary Theory proponents would advocate and offered these options:

      a) That the government has no need to bring the overdraft back to zero each day. They can spend money, and if the overdraft gets big during a recession, so be it; this is effectively the central bank “financing” the government by allowing them to run an overdraft, or

      b) That the government need not debit the overdraft account each time it spends money /at all/. Because it owns the currency, and can do what it likes with it.

      I wouldn’t use terms such as “financing” in either context. The government does not need to finance its spending (in the sense of raising funds prior to spending) and so it is better not to use that terminology. It is misleading.

      Clearly, it is important to run accurate accounts of public spending, if only for researchers and for propriety. So some system of accounts is needed to record the transactions. The reality is that government spending involves some operational officer within government crediting bank accounts or authorising cheques. I don’t see the need for any elaborate accounts with overdrafts etc.

      I would formally consolidate the treasury and the central bank (the idea the latter is independent is a joke – read this blog – Foreclosures – problem or not? for more on that). I would then have a division within this new consolidated entity which handles all the government spending operations. Simple accounting and reporting would be fine.

      Clearly, the concept of an “overdraft” for a sovereign government is rather odd.

      best wishes
      bill

    17. Brianovitch says:

      Bill,
      Many thanks for clarifying gareth’s concerns.

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