Saturday Quiz – December 5, 2009

1. Hi Bill,

   Regarding

   > Central banks (for example, US Federal Reserve, Reserve Bank of Australia, and the Central Bank of Ireland) conduct monetary policy by setting the short-run interest rate rather than trying to control the money supply which is endogenous.

   Let me please ask you again : is Ireland (and each member of the Eurozone) revenue constrained, or not? I’m not talking about the 3% (soft) upper bound on deficits, but the ability to credit bank accounts by decree, which translates into net financial assets. As per

   http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:12002E101:EN:HTML

   I have a feeling the answer is no. BTW, the above rules were already in effect in some countries before the Euro.

   In Deficits 101 you referenced http://www.rba.gov.au/FinancialServices/banking_services.html which states that the RB “provides a facility to the Australian Government that is used to manage a group of bank accounts, the aggregate balance of which represents the Government’s daily cash position.”.

   I guess facility here is to be understood as an overdraft facility, the one by which the government credit bank accounts, and the amount of which equals “net spending”. Furthermore,

   “These banking arrangements include the provision of a term-deposit facility for the investment of surplus funds, the sweeping of balances to and from agencies’ accounts held with transactional bankers, and access to a strictly limited overdraft facility.”

   Is “limited overdraft facility” consequential or unrelated to the proposition that governments are not revenue constrained?

2. BX12,
   Ireland, as a member of the euro zone, is revenue constrained. Government spending is financed through the issue of currency, taxes generate demand for that currency that results in sales to government, bond sales merely substitute bonds for cash, and central bank operations determine interest rates and defensively add or subtract reserves. The relation of member countries to the European Monetary Union (EMU) is more similar to the relation of the treasuries of member states of the United States to the Fed than it is of the US Treasury to the Fed. In the US, states have no power to create currency; in this circumstance, taxes really do ‘finance’ state spending and states really do have to borrow (sell bonds to the markets) in order to spend in excess of tax receipts. Purchasers of state bonds do worry about the creditworthiness of states, and the ability of American states to run deficits depends at least in part on the perception of creditworthiness. While it is certainly true that an individual state can always fall back on US government help when required (although the recent experience of California makes that assumption less secure), it is not so clear that the individual countries in the euro zone are as fortunate. Functionally, each nation state operates the way individual American states do, but with ONLY individual state treasuries.

   The euro dilemma is somewhat akin to the Latin American dilemma, such as countries like Argentina regularly experienced. Deficit spending in effect requires borrowing in a “foreign currency”, according to the dictates of private markets and the nation states are externally constrained. That’s why Iceland and Latvia are in a mess and suffer from solvency issues. It’s also why California suffers from a solvency issue or Italy or Spain. Not the US or Japan.

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