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Why do currency-issuing governments issue debt? – Part 1

One question that continually comes up when I do interviews is this: If governments are not financially constrained in their spending why do they issue debt? Usually, the question is expressed in an incredulous tone, meaning that the person asking the question considers this to be the gotcha moment, when they pierce the impeccable logic of Modern Monetary Theory (MMT) and show it for what it is – a sham. One problem is that there is a tendency to confuse motivation with function and many people sympathetic to MMT reduce it to simple statements that belie the reality. One such statement, relevant to this topic, is that government’s issue debt to allow the central bank to maintain a specific short-term interest rate target. Central banks have traditionally used government debt as an interest-rate maintenance tool. But that is a function of the debt rather than being the motivation for issuing the debt in the first place. So we explore those differences today as a means of clarifying the questions and confusions around this issue. This is Part 1 of a two-part series, which I will finish tomorrow.

Pre-World War 2 currency systems

To understand the situation now, one has to understand what went before.

During the C18th, so-called commodity currency systems, where a currency might be valued for its intrinsic value. became problematic because there was a shortage of silver and this system steadily gave way to a system where paper money issued by a central bank was backed by gold.

So the idea was that a currency’s value can be expressed in terms of a specified unit of gold.

To make this work there had to be convertibility which meant that someone who possessed a paper note would be able to convert it for the relevant amount of gold.

So the – Gold standard – was deployed where the value of currencies around the world was regulated in terms of a certain amount of gold. When the gold standard was in vogue (C19th into the C20th) it was the major way that countries adjusted their money supply.

Britain adopted the gold standard in 1844 and it became the common system regulating domestic economies and trade between them up until World War I. In this period, the leading economies of the world ran a pure gold standard and expressed their exchange rates accordingly.

The monetary authority agreed to maintain the ‘mint price’ of gold fixed by standing ready to buy or sell gold to meet any supply or demand imbalance. Further, the central bank (or equivalent in those days) had to maintain stores of gold sufficient to back the circulating currency (at the agreed convertibility rate).

Gold was also considered to be the principle method of making international payments. Accordingly, as trade unfolded, imbalances in trade (imports and exports) arose and this necessitated that gold be transferred between nations (in boats) to fund these imbalances. Trade deficit countries had to ship gold to trade surplus countries.

Nations experiencing an inflow of gold could then expand the money supply (issue more notes) because they had more gold to back the currency. This expansion was in strict proportion to the set value of the currency in terms of grains of gold.

The rising money supply would push against the inflation barrier (given no increase in the real capacity of the economy) which would ultimately render exports less attractive to foreigners and the external deficit would decline.

Central banks in nations experiencing a loss of gold reserves were forced to withdraw paper currency which was deflationary – rising unemployment and falling output and prices. The latter improved the competitiveness of their economy which also helped resolve the trade imbalance. But it remains that the deficit nations were forced to bear rising unemployment and vice versa as the trade imbalances resolved.

The proponents of the gold standard focus on the way it prevents the government from issuing paper currency as a means of stimulating their economies.

Under the gold standard, the government could not expand base money if the economy was in trade deficit. It was considered that the gold standard acted as a means to control the money supply and generate price levels in different trading countries which were consistent with trade balance. The domestic economy however was forced to make the adjustments to the trade imbalances.

Monetary policy became captive to the amount of gold that a country possessed (principally derived from trade). Variations in the gold production levels also influenced the price levels of countries.

In practical terms, the adjustments to trade that were necessary to resolve imbalances were slow.

In the meantime, deficit nations had to endure domestic recessions and entrenched unemployment.

A gold standard introduces a recessionary bias to economies with the burden always falling on countries with weaker currencies (typically as a consequence of trade deficits).

This inflexibility prevented governments from introducing policies that generated the best outcomes for their domestic economies (high employment).

Ultimately the monetary authority would not be able to resist the demands of the population for higher employment.

The onset of World War I interrupted the operation of the gold standard and currencies were valued by whatever the specific government wanted to set it at.

The ensuing 25 odd years saw significant instability with attempts to go back to the standard in some countries proving extremely damaging in terms of gold losses and rising unemployment.

The UK abandoned the gold standard in 1931 as it was facing massive losses of gold.

It had tried to maintain the value of the Pound in terms the pre-WW1 parity with gold but the war severely weakened its economy and so the pound was massively over-valued in this period and trade competitiveness undermined as a consequence.

Debt issuance under the Bretton Woods system

In an effort to achieve currency stability at the end of World War 2. the Bretton Woods System was introduced in 1946 and created the fixed exchange rates system.

This was the creation of the so-called – Gold exchange standard – to replace the flawed gold standard.

The IMF was also created to act as the multilateral lender to nations to ensure they could maintain the agreed exchange rate parities.

Convertibility to gold was abandoned and replaced by convertibility into the USD, reflecting the dominance of the US in world trade (and the fact that they won the War!).

This new system was built on the agreement that the US government would convert a USD into gold at $USD35 per ounce of gold. This provided the nominal anchor for the exchange rate system.

Governments could now sell gold to the US Treasury at the price of $USD35 per ounce.

The fixed exchange rate system however rendered fiscal policy relatively restricted because monetary policy had to target the exchange parity.

If the exchange rate was under attack (perhaps because of a balance of payments deficit) which would manifest as an excess supply of the currency in the foreign exchange markets, then the central bank had to intervene and buy up the local currency with its reserves of foreign currency (principally $USDs).

This meant that the domestic economy would contract (as the money supply fell) and unemployment would rise.

Further, the stock of $USD reserves held by any particular bank was finite and so countries with weak trading positions were always subject to a recessionary bias in order to defend the agreed exchange parities.

The IMF functioned to provide currency reserves if needed, but increasingly (in the 1960s) adopted conditionality (austerity) as part of the deal which was counterproductive.

The system became politically difficult to maintain because of the social instability arising from unemployment and austerity.

If fiscal policy was used too aggressively to reduce unemployment, it would invoke a monetary contraction to defend the exchange rate as imports rose in response to the rising national income levels engendered by the fiscal expansion.

Ultimately, the primacy of monetary policy ruled because countries were bound by the Bretton Woods agreement to maintain the exchange rate parities. They could revalue or devalue (once off realignments) but this was frowned upon and not common.

Whichever system we want to talk off – pure gold standard or USD-convertible system backed by gold – the constraints on government were obvious.

The gold standard as applied domestically meant that existing gold reserves controlled the domestic money supply. Given gold was in finite supply (and no new discoveries had been made for years), it was considered to provide a stable monetary system. But when the supply of gold changed (a new field discovered) then this would create inflation.

So gold reserves restricted the expansion of bank reserves and the supply of high powered money (Government currency). The central bank thus could not expand their liabilities beyond their gold reserves (although it is a bit more complex than that). In operational terms this means that once the threshold was reached, then the monetary authority could not buy any government debt or provide loans to its member banks.

As a consequence, bank reserves were limited and if the public wanted to hold more currency then the reserves would contract. This state defined the money supply threshold.

The concept of (and the term) monetisation comes from this period. When the government acquired new gold (say by purchasing some from a gold mining firm) they could create new money.

The process was that the government would order some gold and sign a cheque for the delivery. This cheque was deposited by the miner in their bank.

The bank then would exchange this cheque with the central bank in return for added reserves.

The central bank then accounted for this by reducing the government account at the bank.

But in terms of today’s post, this history is important.

A major implication of this system was that the national government could only increase the money supply by acquiring more gold.

Any other expenditure that the government desired to make would have to be ‘financed’ by taxation and if they wanted to spend more than their tax revenue, they had to issue debt.

Debt-issuance was required to ensure the monetary authority didn’t lose control of the exchange rate.

Governments were not able to just credit a commercial bank account under this system via their central banks in order to increase their net spending independent of its source of finance.

As a consequence, whenever the government spent it would require offsetting revenue in the form of taxes or borrowed funds.

Ultimately, Bretton Woods collapsed in 1971.

It was under pressure in the 1960s with a series of “competitive devaluations” by the UK and other countries who were facing chronically high unemployment due to persistent trading problems.

Ultimately, the system collapsed because Nixon’s prosecution of the Vietnam war forced him to suspend USD convertibility to allow him to net spend more.

He announced that the US was abandoning the convertibility system on August 15, 1971, which paved the way for the introduction of fiat currencies.

This was the final break in the links between a commodity that had intrinsic value and the nominal currencies.

From this point in, governments used fiat currency as the basis of the monetary system.

And on an historical note, this is the ‘modern’ part of MMT – it applies to monetary systems post Bretton Woods.

Now what difference did this make to the debt-issuance motivation?

Fiat currency systems

The move to fiat currencies fundamentally altered the way the monetary system operated.

This system had two defining characteristics:

(a) non-convertibility; and

(b) flexible exchange rates.

You need to recognise this major shift in history before you can understand why the economic policy ideas that prevailed in the previous monetary systems (based on convertibility) are no longer applicable.

You cannot assume that the logic that applied in the fixed exchange rate-convertibility days translates over into the fiat currency era.

Mainstream macroeconomic reasoning is really the sort of reasoning that prevailed in the days prior to fiat currency.

While there were debates about how to conduct macroeconomic policy in those days, there were some obvious key constraints that I have outlined above.

This is irrespective of whether you want to call yourself a Keynesian or a Monetarist.

The shift in history also renders most of the textbook economics outdated and wrong, in terms of how they depict the operations of the fiat monetary system.

The collapse of the Bretton Woods system dramatically altered the opportunities available to currency-issuing governments.

First, under a fiat monetary system, ‘state money’ no longer any intrinsic value.

It is non-convertible which means that you can take, say, a $AUD coin to the government and in return you will get a $AUD coin back. There is no responsibility to do more than this.

So for this otherwise “worthless” currency to be acceptable in exchange (buying and selling things) some motivation has to be introduced. That motivation emerges because the sovereign government has the capacity to require its use to relinquish private tax obligations to the state.

Under the gold standard and its derivatives, money was always welcome as a means of exchange because it was convertible to gold which had a known and fixed value by agreement. This is a fundamental change.

Second, given the relationship between the commodity backing (gold) and the ability to spend is abandoned and that the Government is the monopoly issuer of the fiat currency in use (defined by the tax obligation) then the spending by this government is revenue independent.

It can spend however much it likes subject to there being real goods and services available for sale. This is a dramatic change.

Irrespective of whether the government has been spending more than revenue (taxation and bond sales) or less, on any particular day the government has the same capacity to spend as it did yesterday. There is no such concept of the government being ‘out of money’ or not being able to afford to fund a program.

How much the national government spends is entirely of its own choosing. There are no financial restrictions on this capacity.

This is not to say there are no restrictions on government spending.

The constraints become the available real goods and services available for sale, including all the unemployed labour.

So we traverse from thinking about financial constraints and the need to ‘fund’ spending to avoid compromising central bank responsibilities to maintain a particular exchange rate parity, to a focus on real resource constraints defined in terms of available productive resources and available final goods and services.

This is a dramatic shift in thinking.

It doesn’t mean that the spending, taxing and borrowing decisions of the national government do not impact on interest rates, economic growth, private investment, and price level movements.

Third, what it means is that the gold standard rationale for issuing public debt is no longer applicable.

In a fiat currency system, the government does not need to ‘finance’ its net spending (deficits), in which case the issuing of debt by the treasury has to serve other purposes.

Why then do governments continue to issue public debt when there is no financial need for them do to so?

Conclusion

We have established an important understanding today – that the usual justifications for currency-issuing governments issuing debt are not sustainable.

In Part 2, we will consider some of the other justifications.

We will see that none are sustainable.

That is enough for today!

(c) Copyright 2020 William Mitchell. All Rights Reserved.

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    This Post Has 28 Comments
    1. It is instructive to me that states have repeatedly abandoned the gold standard during wartime and other crises — the issuance of “greenbacks” during the US Civil War; the European powers during WWI; the US and UK in the early 30s; Nixon and the Vietnam War.

      These episodes demonstrate that when the state has to exert maximum effort, the gold standard specifically (and commodity money generally) is revealed to be a nonsense. Furthermore, all pretence that the government needs rich people to fund its operations is dismissed as the canard that it is, always and everywhere.

      So why do states that use fiat currency “borrow” the currency over which they exercise a (jealous — try counterfeiting and see what you get) monopoly of issue? In part by convention as a holdover from gold standard era, mercantilist thinking, but more so because our government is by and for the wealthy — the government offers interest bearing debt as a favour to currency users (households and firms) that have a propensity to save; the rich save the most, so they benefit most from this arrangement.

    2. Thanks. I think this is an important post.

      I don’t want to interrupt you, but I expect to argue a bit about the trade thing and how MMT understands it. After your next post of course.

    3. Bill, you wrote, “So for this otherwise “worthless” currency to be acceptable in exchange (buying and selling things) some motivation has to be introduced. That motivation emerges because the sovereign government has the capacity to require its use to *relinquish* [did you mean extinguish?] private tax obligations to the state.”

    4. “the government offers interest bearing debt as a favour to currency users (households and firms) that have a propensity to save; the rich save the most, so they benefit most from this arrangement.”

      Not sure that analysis stacks up in reality any more.

      When you look at the actual holders of “government debt” you’ll find that it is the pension funds that hold them – either in the country or abroad, and the banks. Pension funds that are increasingly in receipt of “compulsory pension contributions” (aka privatised taxation).

      The banks hold government debt domestically so they can still pretend that a modern banking system is fully collateralised and internationally as collateral so they can pretend they are still operating some sort of “Gold Standard” when they issue their own money.

    5. On another site I posted this
      “… The world’s Govs are deficit spending like crazy and their central bank is buying the resulting bonds; however, we are also hearing that “someday we are going to have to pay this all back”. WTF, why in hell would a Gov. tax its people to pay off bonds that it owes to itself? {I know the Fed. is sort of ‘independent’, but all its profits (97% of its receipts) are paid into the US Treasury.}
      As I have said, this looks a lot like a person buying stuff by making loans. That is don’t give them money for their ‘thing’ but just lend them money, while saying you will want the money back some day. Is such a contract even legal?”

      I’m asking you here, is this legal for a person?
      And, does it make any sense *at all* for the US Gov.?

      BTW, is it OK here to use *XXX* to indicate words I want to emphasize? And so avoid all capitals.

    6. Thanks, Bill. I’m writing an article for Morning Star and trying to make it as clear as possible. Have had to edit as a result of this blog – and probably tomorrow’s!

    7. ‘Any other expenditure that the government desired to make would have to be ‘financed’ by taxation and if they wanted to spend more than their tax revenue, they had to issue debt.

      Not sure why Bill uses the inverted comma with ‘financed’ in this context. I have a vague memory of Randy Wray writing somewhere that Governments often issued paper well in excess of gold so that there was almost a degree of fiat-like behaviour about while ostensible being on the standard.

      In the latter context the gold value would fluctuate so cease to be a numeraire in any reliable way.
      Not sure I’ve remembered this correctly and will have to check it out.

      There was a very interesting and informative blog post by Bill on the suspension of gold during the Napoleonic Wars. Inflation rates during that period seemed to have been very volatile.

      Need to do more reading on this – but as Jerry says, important post today clearing up function/motivation confusions.

    8. “WTF, why in hell would a Gov. tax its people to pay off bonds that it owes to itself?”

      That happens naturally. When you stop saving in bonds and spend the savings, the flow is taxed all the way down the spending chain the release of savings induces and that eliminates an amount of deficit that will be the exact equivalent to the bond (assuming no further saving downstream).

      The answer is there for “the debt is paid off when the balancing asset is spent”. Just like any other decapitialisation event in modern accounting.

      There’s no mystery to it.

      Perhaps anybody who doesn’t get it should be forced to watch the Dark Crystal until they understand why a Mystic disappears every time a Skeksis dies.

      I note that the remaining Monetarists are getting very agitated at all this “pent up savings” which obviously nobody is going to hold onto once lockdown ends. And they are getting agitated about this despite the money being “neutralised” by bond sales.

      Apparently there is a battle between the New Keynesian view and the Monetarist View. The possibility that both of them are wrong doesn’t appear to be considered…

    9. Neil, Dark Crystal metaphor. Nicely done. Been some time since I have seen it, but I loved it. Thanks for the reminder.

    10. Thank you so much for this post bill, one of your most important in terms of historical understanding. Can’t wait for tomorrow. It’s my birthday tomorrow, so part 2 will be my special intellectual treat!

    11. Neil Wilson,
      Sorry I don’t know you. You seem new here.
      WADR, you seem like a neo-lberal economist.
      Your reply to me makes no sense to me. I’m no expert so it could be all my ignorance.
      However, it sounded like you were saying that if the US Gov. just stopped selling bonds and deficit spent cash into the economy. This would make paying off the bonds easy.
      Well, not one of the naysayers talking about paying off the bonds being currently sold WOULD IMAGINE THAT THE US GOV. WOULD JUST SPEND CASH INTO THE ECONOMY UNTIL ALL THE BONDS WERE REPAID.
      The naysayers would see that as *cheating* on a par with just calling all the bonds in and paying them with magic money tree dollars in one week.

      But, I say again, I’m no economic expert. So, it is likely that I misunderstood what you said there.

    12. To Steve_American and Neil Wilson. Federal Reserve chairman Jerome Powell explained that he did not fear inflation that much, and when asked about handling increasing public debt levels, he said that after the GFC the Feds allowed excess debt to ‘roll off’ in that the maturing debt was not replaced by new debt. Therefore, over the 9 years since the GFC and the current face plant by capitalism, the public debt declined considerably. Following this reality, it’s not a logical stretch to envision a continued ‘rolling off’ of debt after this pandemic. Nor a logical stretch to notice that public debt can, and in my belief system, should be reduced significantly even if no capitalism collapse occurs going forward. Of course capitalism collapses on a regular bases, so my preferred technique to not use public debt, but rather to use Overt Monetary Finance (direct spending unadorned by debt and interest costs) may never gain dominance. As an addendum, JM Keynes noticed that under a gold standard, it was easier to adjust exchange prices between nations than to adjust prices domestically. Particularly wages, because labor compares nominal prices to judge whether or not they are being sufficiently paid. It takes time for labor to re-consider and then negotiate higher priced wages: Compared to exchange adjustments made between nations. And of course getting wage cuts is also much more difficult. In today’s mythical, neoliberal framework it is a little easier to screw labor because it has been castrated.

    13. Steve_American
      Monday, June 1, 2020 at 21:19

      Neil Wilson is far from “new”, but he has been on furlough for a couple of years. Listen to him – he knows what he is talking about.

    14. From curiosity, I’ve been trying to get inside the heads of gold-standard people. Reading
      * _The Lords of Finance_ by Liaquat Ahamed; popular economic history around WW1 and the Crash of ’29,
      * _Foreign Exchange_ by Robert Owen Latham; 1919 monograph by a U.S. Senator, chairman of the Committee on Banking and Finance (available at Project Gutenberg,)
      * eventually a look back at Keynes’ _The Economic Consequences of the Peace_ and maybe Bagehot’s _Lombard Street_ (also Project Gutenberg, both.) (Project Gutenberg needs more Keynes.)
      So far I’ve got to 1925, and the big sub-plot then. The nations in Europe had bent the gold-standard rules to fight their war, and were trying in individual ways to reassemble their peacetime societies.
      The U.S. had cornered a huge proportion of the Western gold supply by selling to the belligerents. U.S. then bent the gold-standard rules by not expanding their money supply to match all that gold. We usually read about having to shrink the currency due to a lack of gold, this was the opposite. This suppressed U.S. domestic demand, kept the value of the dollar low (even though a US$ was still worth 30 or 40 French francs – Robert Owen Latham would have thought it should be 4), and preserved the U.S. ability to export, and collect gold, even after the war was over. It echos Germany’s present position in the Eurozone, where grabbing even a small corner of a scarce medium of exchange creates a trade advantage that’s self-reinforcing.

    15. It is a shame Neil stopped blogging, I liked reading 3Spoken. Maybe him coming back around hints the ink might overflow again ;)

    16. “I’m no expert so it could be all my ignorance.”

      You might think that. I couldn’t possibly comment.

    17. Steve American and anybody else interested in the legal structure behind the monetary system would do well to read an excellent detailed paper by Rohan Grey “Administering Money: Coinage, Debt Crisis, and the Future of Fiscal Policy”. It’s a bit weighty, and you’ll have to search for it as I don’t have a link. You also need to understand the process that authorises institutions to act as banks, which takes around a year in the UK, at the end of which they get a licence.

    18. Hi Neil,

      Yes, it’s great to see you back here injecting your pithy insights.

      It would take me forever to find your comment of 7th July 2010.

      Was it where you said that “in the limit”, taxation is 100%?

    19. Great article that very clearly pulls together the historical strands leading up to modern money. Couldn’t be easier to understand – Gold Standard – Bretton Woods – Fiat. Makes sense to me – traditional macro treats our monetary system as if it were still on a gold standard rather than recognising the benefits of a fiat currency and the opportunities it gives sovereign currency issuers. Great piece. Clarified a lot in my mind.

    20. Dear Bill,
      I agree with all the comments that your latest piece is a great writing and very much welcomed. I look forward to reading the 2nd part tomorrow also.

      I read your MMT textbook few months after it first came out. It did not discuss in details on this issue like what you are doing now. Thank you very much for the additional insights.

      I like to add also that I always enjoy readings all the comments from the readers. They bring to the table interesting, relevant, expansive and further insights. Thank you all greatly!

      If this forum is not the greatest final oral PhD defense meeting room for any realistic economic thesis proposals, i don’t know which one is.
      vorapot

    21. @ Neil Wilson 18:00

      I don’t believe that we are disagreeing. Yes, pension funds and banks hold shedloads of sovereign debt. The rich disproportionately own and run the latter, much as they own and run the governments.

    22. There was a federal government borrowed extensively from its own central bank?
      “The Bank of Canada Should Be Reinstated To Its Original Mandated Purposes
      John Ryan / March 21, 2018
      The critical point is that between 1939 and 1974 the federal government borrowed extensively from its own central bank. That made its debt effectively interest-free, since the government owned the bank and got the benefit of any interest. As such Canada emerged from World War II and from all the extensive infrastructure and other expenditures with very little debt. But following 1974 came a dramatic change.
      After its meeting with the international bankers’ Basel Committee in 1974, the federal government proceeded to borrow the bulk of its needed money, with interest charges, from private investors including banks and dramatically reduced dealing with its own bank that had no interest charges. This was done in secret and without the approval of parliament.”

    23. @eg
      You are close to the crux of the problem but are still mired in libertarian/hard money thinking.
      The rich don’t “save” under a hard money currency system – they leverage their monopolistic/monopsonistic holdings of capital to gain maximum economic leverage for themselves.
      Standard Oil didn’t “save” its way to primacy – it spent to buy out its competitors to form a monopoly. IBM did the same for “computing engines”. US Steel. The list goes on and on.

    24. Mel – “From curiosity, I’ve been trying to get inside the heads of gold-standard people”

      Andrew Boyle’s Montagu Norman, a 1967 biography of the Bank of England governor, provides more human interest background about these sometimes bizarre characters and how they inter-related, seen from a British point of view.

      As you may know, the most detailed account of the years 1929-1939 is probably Charles Kindleberger’s The World in Depression. Very dry but full of facts and figures about international (mainly US/European) financial developments during the period, organized chronologically.

      Personally, I found Michael Hudson’s Super-Imperialism a real eye-opener – a brilliant history of the rise of the US as the global financial superpower from 1917 to 1973. It’s available free on Hudson’s website: michael-hudson.com/wp-content/uploads/2010/03/superimperialism.pdf

    25. Norman,
      Thanks. I did not know about Boyle and Kindleberger. Ahamed does deal briefly with the personalities of the four central bankers: M.Norman, Schacht, Strong, and Moreau, but not so much with the dozens of other leaders outside the Central Banks. I have the Hudson book — awaiting a burst of stamina. Thanks again.

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