The other day I introduced a simple model of how a monetary economy works. The model was centred on the payments of my business cards to elicit labour from the kids that live in my house. All the basic national accounting results that apply in a real economy were present. The simplicity extended to considering only two sectors – the kids (private) and the “house” (public). In terms of modern monetary theory (MMT) we start by examining the broad relationships between the government and non-government sector, where the latter comprises the private domestic and foreign sector. Some readers have suggested that the results obtained would not apply if I had have explicitly modelled the cross-border flows (that is, the external sector). Well today, I have some news … some neighbours have arrived next door to my place and the kids from each house are jumping fences.
To get back intp the scheme of things here is a brief recap of where we left my simple household business card economy. As background reading I suggest the following blogs – A simple business card economy and What causes mass unemployment?.
The following briefly refreshes our memory of the model presented in this blog – Barnaby, better to walk before we run. I strongly recommend you re-read (or read) that blog to see the most simple exposition of the model. You will see that things get more complicated in the model I present today.
- I devise a plan to get my children to work around the house which involves me offering them by worthless business cards each month as wages. The children are disinterested in the plan initially but soon realise they have to pay me taxes each month in business cards. The imposition of the tax creates a demand for my otherwise worthless cards.
- All wage payments, taxes and interest payments are demoninated in cards and transacted via entries into a spreadsheet we keep on our home computer system.
- The kids cannot pay their taxes until I spend the cards on wages. Taxes are not levied to raise revenue. I am totally free to create as many business cards as I choose.
The following Table summarises the main results of the system before trade enters the picture. For a large printable version of the 9-month sequence that is discussed click HERE. It is best viewed in a landscape format.
You will notice it is a bit more complicated than the spreadsheet tables presented in the companion blog last week. The spreadsheet we keep in the house now defines the overall spending aggregates – public spending (G) which is total wages and interest payments; exports (X) and imports (M) (more about which later). Total output in the family is equal at this stage to total public spending.
You then see the public spending and revenue accounts, the budget balance [Taxes (T) – Total Public Spending(G)] and the national debt (outstanding bonds issued).
The next set of entries relates to the kids accounts. They can earn wage and interest income but pay taxes. Total private saving (S) is the difference between total house income and taxes.
The next set of entries details the so-called sectoral flows. We have three sectors interacting: (a) public (me); (b) private domestic (kids); and (c) external (relations with our next door neighbours although in Months 1 to 4 they house next door is empty.
The national accounting rules relating to these sectoral flows ensure the balances (correctly specified) sum to zero. So S + (T – G) – (X – M) = 0. This is not an idea or theory but an accounting rule that always holds in any economy. That is, it cannot be wrong.
The final two sets of entries relate to the wealth accounts of the kids and the next door neighbours. Our kids can choose to hold their accumulated saving in the form of cash (in cards) or purchase a bond (also specified in cards).
Once trade begins you will see that the kids next door can also buy bonds that I issue as long as they have my business cards – remember I am the only person who issues these cards. The kids next door will also receive interest payments denominated in my cards for any bonds they buy off me.
Recap: Months 1 to 4
In Month 1, I run a balanced budget which is, from inception, the MINIMUM that can be spent, without a continuous deflation. That is, the kids would not be able to earn at least as much as they needed to pay taxes.
If the budget is balanced there can be no net saving or net accumulation of financial assets.
In Month 2, I agree to the kids’ desire to save some business cards so they can temporally arrange their work load and have holidays. The children’s desire for thrift forces me to run a deficit as a matter of course. They cannot save in the currency unless I am spending more than I tax them.
So the desire increases the level of activity in the economy by 200 cards per month and the extra employment generates higher incomes and permits the children to save 200 cards a month.
The principles now understood include the finding that public deficits allow the private sector to net save in the fiat currency and accumulate financial assets. In this case the saving is in the form of non-interest earning business cards.
Further, the accumulated saving of financial assets is the stock of wealth and reflects the accumulated fiscal deficits. The stock of past savings as it stands do not earn any interest. Another way of looking at this is that there is excess liquidity (spare cards) in the overall system and the rate of interest is zero.
To reward thrift, I introduce a new financial asset – a bond in Month 3 which will pay 10 per cent on all cards saved. The payments are made with respect to last period’s stock of bonds. So all accumulated cash (card) savings are converted to bonds (400 in Month 3). The bonds are recorded in the spreadsheet and have instant maturity (that is, can be converted back into cards at any time).
In Month 4, I start paying interest income on the outstanding stock of bonds so in addition to wage income (800 cards) I pay 40 cards in interest income. The payments are made in the same way as all spending – I just calculate the amount owing and enter the number in the spreadsheet. Just an accounting entry. The kids notice that their non-wage income has increased which allows them to further accumulate wealth.
Seems as though everyone is happy. I am using my fiscal capacity to deploy otherwise idle labour which created income. The income, in turn, generates the capacity to save as long as I run deficits which I am happy to do. The only cost to the household in all of this are the real resources being consumed in the the process of generating the income. The spreadsheet entries are all costless.
What we all realise in this household is that the accumulated public deficits equal the accumulated private savings, which, in turn, sums to the accumulated stock of financial assets. This stock of financial assets can be split between cards and bonds as per the preferences of the children.
It is also clear that the rate of interest would be zero unless I issue the bond or agreed to pay an interest rate on the saving balances. The bonds cannot be bought by the kids unless I have previously spent an equal sum of cards. The bonds do not “finance” my business card spending in any way at all.
Here is the spreadsheet accounts describing the first four happy months of our household. I assess the kid’s have as much work as they desire and so the household is at full employment. There is enough demand to allow them to save cards for future use (like buying some other labour to allow them a holiday in one month or more).
So far so good.
Some neighbours arrive
After lying empty for 4 months or more, the house next door suddenly becameoccupied at the beginning of Month 4. Yes, a lovely family arrived to take up occupancy.
I believe they are called the China family. Their kids are very eager to work and my kids are very eager to use some of their income (cards) to pay them to work.
Further, Dr. China (the female parent next door) has introduced a similar scheme to the one that has been successfully operating in my place for the past four months – she is paying and taxing her kids in her business cards to motivate them to work around her house.
Given the fences are easy to jump over, what emerges in Month 4 is that our kids and the China Family kids start doing deals. The work in each house is not identical. Our kids are happy to work over there and they have found the next-door neighbours kids are happy to work in our house doing things.
The work our kids do next door amounts to our house resources earning income next door which we might call Export (X) income. They are paid in China Business Cards (CBC) which they can hold in that denomination or convert at the fence into my business cards. I abstract from the inner workings of the foreign exchange market that operates on the fence perimeter. That is another story but does not undermine any of the main results here.
I am happy to allow my kids to pay the China Family kids to work in our house in my business cards that they either earn or have saved. This allows them to work less if they desire. So it is like substituting saving for leisure. The work that the China Family kids do around our house amounts to us leaking some of our domestic spending (income) over the fence and we might call this Import (M) expenditure.
The China family kids convert my cards into CBC or hold them as they see fit. I am also happy to allow the China Family Kids to buy my bonds and earn interest in the same way that my kids can if they want to hold their accumulated saving in this way. Of-course, I only accept my cards in return for a bond and all my interest payments are in my cards.
All transactions are maintained in my spreadsheet system which the kids call the “central bank” because they learned at school that they can keep their accumulated saving in a “bank”.
An exchange rate (the relative price between my cards and CBC) emerges and reflects the relative demand and supply of the two types of business cards. So if exports are less than imports (which we might call net exports (NX) < 0)) then there are more of my cards being supplied in exchange for CBC and so the price of my cards relative to CBC falls - we might call this a depreciation. The opposite holds. Initially the parity is 1 but that soon changes due to "market forces". That is, we decide not to peg our exchange rates because it would tie up our days worrying about it. Each family aims to maximise welfare using its respective card fiscal policy and to keep it free from having to worry about pegs.
I soon noted that, in general, the willingness of my kids to pay the China Family kids to do work in our house rose with total income but fell somewhat when my cards were depreciating against the CBC and vice versa. Note: the capacity to export might also rise when my cards depreciated against CBC but for simplicity I have made this sensitivity zero. It doesn't alter anything of substance.
At the outset, I notice that both sets of parents are happy that their kids are being industrious and jumping the fence to earn each other's cards. However, the China Family appears to have a curious attitude - they are happy to "export" more labour services to our house and accumulate my business cards than the labour services they get back in return.
It is clear to me that exports are costs (my kids could be working around our place instead of next door) while imports are benefits (the China Family resources improving our welfare). So it was curious that the China Family would want to give us more real resources than we had to give them just to accumulate my business cards. No telling though ... people are different.
But the China Family attitude certainly enhances our welfare - we get more net real resources and I am happy that lots of work is being done around the house and my kids are happy that someone else is doing it.
To understand the impact of the neighbour's arrival we also have to redefine total income produced in our household per month (a flow). Prior it was just my spending (on wages and interest payments). Now, we earn "export" income which has to be added to the "public" spending (G) but we lose the "import" spending to the China Family.
So we define the total household GDP to be equal to G + X - M, which is something I read in some textbooks as well!
Month 5 – trade begins
As you will see, things now get more complicated.
Given the China Family attitude to importing and exporting and my kids’ attitude to substituting leisure for work in Month 5 a trade deficit soon opens up. We export our labour worth 30 cards and they provide us with 148 cards worth of work which leads to a trade deficit of 118 in Month 5. The exchange rate depreciates as a result which has some attentuating impacts next period.
I am still paying out 800 in wages and now I am paying 64 cards in interest servicing payments (because the kids had accumulated 640 cards as bonds at the end of Month 4).
So total house income (GDP) in Month 5 = 864 + 30 – 148 = 746. So you can see that the household economy contracts because of the leakage in imports outweighing the injection from exports but my kids are working less by choice.
The public deficit rises to 264 cards (spending = 864 and taxes = 600). This deficit is now not fully added to the national debt because the kids use some of the potential saving to purchase imports. So they save 146 cards in Month 5 courtesy of my fiscal deficit (minus their import spending) and their bond holdings (wealth) rises by the same amount.
Notice also that the China Family kids have also accumulated 118 of my cards which they also convert into bonds. I create some new rows on the spreadsheet to record this and give them copies. These bonds will earn interest for them next period but all spending on this will remain in terms of my cards and inject extra cards into the household economy.
Overall, the national debt is now 904 cards (sum of my kids’ and the China Family kids’ bond holdings).
You will also clearly appreciate that the China Family kids (or their parents) have played no role in allowing me to spend my 864 and run a deficit of 264 cards in Month 5. I would have still run a deficit by choice and if they didn’t want to allow us to import as much then domestic income and saving would be higher and my deficit would be slightly lower.
Finally, the sectoral balances are more complicated than before trade was introduced. We will consider them separately in the next main section. But you can see that the sum of the balances still adds to zero, as is dictated by the national accounting framework.
Month 6 – a neo-liberal inspired fiscal austerity program begins
As we learned in the simple model without neighbours, one night I started to read about the dangers of public spending and deficits. I spend the whole night while the kids were safely sleeping on the Internet reading neo-liberal economics literature.
The literature was at odds with what I was observing. Everyone seemed to be happy and working hard and enjoying life around the house and I was certainly getting the tasks I wanted done performed by the kids.
But the economists and some Youtube videos I watched (by someone saying they were from the Austrian gold standard libertarian school of thought) were really scary.
My budget was about to blow out and become viral. The interest rates I would have to pay on the debt would sky-rocket because no-one would want to hold it at 10 per cent. Funny I thought, I don’t actually care if they hold cash balances or bonds. I thought I was doing the kids a favour offering them a interest-bearing asset. But that is not what the literature said. Viral!. Okay, that’s scary.
It was also clear from the literature that I had become hostage to the China Family who were now funding my deficits and would pull the pin on me anytime soon because they wouldn’t want to hold anymore of my bonds. Funny, I thought – my spreadsheet was encrypted so they couldn’t hack into it. I just sat there typing in numbers each month to determine by wage payments. They were my business cards after all – the China Family had their cards (CBC) but mine were mine.
But the liberatarian person – I actually had to turn the volume down while listening to him down because he had such an abrasively whining voice that sounded as if he knew nothing – but he had said the China Family would undermine our welfare. I didn’t want that.
The literature also said I would have to impose punitive taxation on my kids to get my budget deficits down and into surplus and pay back the national debt. Paying back the debt had to my priority it said. Further, high taxation would undermine the incentive of the kids and they would just refuse to work.
Funny, I thought, they were really happy to be working at present and using the increased income, savings and wealth to buy in real resources from elsewhere to make things even better.
They also were really pleased to buy the debt I offered them because they got a little extra reward for their saving. Also if they refused to work how would they pay the taxes anyway? The fact they had to get by cards to pay the taxes and therefore remain living in the house was the reason they offered to work in the first place.
The literature was adamant. I read newspaper columns and IMF papers. I bought Mankiw – which I learned was a famous textbook. I couldn’t believe how expensive it was but it must be worth reading at that price.
All these sources were telling me … I needed a credible exit strategy!
So in Month 6, I follow the advice and implement a fiscal austerity plan by cutting back on the amount of work I am prepared to pay for. I only offer 450 cards in that month to my kids. I note that exports (the amount of work my kids do over the fence) does not change (they can earn of my 30 cards when converted).
The dramatic decline in income plus the depreciating exchange parity between my cards and the CBC work together to reduce the trade deficit. Yes, I had also read that the trade needed to be rebalanced and I could not longer keep running a trade deficit, even though I had always thought they were delivering net real benefits. Anyway, imports (the China Family kids working here) falls to 94 and net exports falls to a deficit of 64 (down from 118).
The literature indicated that some short-term income losses would occur but in the long-run demand (fiscal) policies were not determining in terms of income growth. So I wasn’t concerned that our national GDP had fallen from 746 cards to 476 cards per month in Month 6. This was going to be a short sharp shock to get everything back on track.
But I must admit I hardly gave the other aggregates much attention because I was noticing I was back into a budget surplus. With total G = 540 and T = 600, I turned in a beautiful number – a 60 card surplus in Month 6. All other issues were rather insignificant given my goal to get back into surplus. The exit plan was working.
I call a family meeting and said:
We have had to “pull our belts in” and that it was time to be fiscally responsible. I had to set the household economy back on the path to fiscal sustainability. This surplus will underpin future growth once I get the national debt off our backs.
I quoted Mankiw about all of this but no-one knew what I was talking about.
The kids just looked on edge and said something about their savings were drying up and they couldn’t get as much work as they wanted and the China Family kids were now staying over their side of the fence a bit more. They also said that in Month 6 they had to sell 124 cards worth of bonds they were holding to meet the shortfall between income and tax obligations.
So they claimed they were not as well of as before. I told them “we all have to pull our belts in and do our bit to get this house economy back on track”.
When I examined the spreadsheet further I noticed that I had indeed retired 60 cards worth of the national debt – by buying back 124 card bonds from my kids while still selling 64 card bonds to the China Family (as a result of the on-going current account deficits).
But there was still 844 cards of debt outstanding.
I also noticed the China Family had accumulated even more debt as a result of the on-going trade deficits and this needed to be addressed. I had to get rid of the trade deficits as well as the national debt.
I also noticed my interest payments were still rising. That signalled to me that next month even tougher measures were required or I might go broke as the neo-liberal literature had been warning me.
However, if I had stayed reading billy blog I would have realised that:
- Budget surpluses squeeze the private sector for liquidity and the private sector is forced to run down wealth through negative saving in order to meet their tax obligations.
- Budget surpluses destroy private wealth!
- When the government is in surplus and the external sector is in deficit, the private domestic sector must be dis-saving and running down their wealth.
Months 7 and 8 – budget surpluses grow, private (kids’) wealth falls
From the neo-liberal perspective, my strategy as the government of the household has been exemplary. I am now generating surpluses and retiring debt. I am no longer living beyond my means. I fail to notice that the kids’ (private sector’s) wealth is being destroyed and they are unable to work as much as they want.
However, I read in one of the articles that it was highly likely that the kids didn’t want to work anyway – they probably had attitudinal problems or were demanding excessive earnings. So if the rising unemployment was voluntary anyway and the kids were enjoying leisure more what is the problem?
I also fail to notice that the kids who hadn’t accumulated any wealth are facing rising debts. They seek to borrow from other kids because their work opportunities are being limited and they have to pay their taxes still.
Anyway, bouyed by all my economic reading and the events in Month 6, I decide that I should try to wipe out all the national debt. So in months 7 and 8 I extend the fiscal austerity and cut spending to 400 then 350 cards per month. I also note that my interest servicing payments on the outstanding debt are falling (84 then 73 cards per month). All this is heading in the right direction.
I thus enjoy increasing surpluses of 116 (Month 7) and then 177 (Month 8).
I also read about the twin-deficits thesis which said that budget deficits drive up current account deficits and so you have to reverse that process. I note in this regard that the trade deficit is narrowing dramatically as total house economy income (GDP) falls from 429 to 378 over the two months.
In Month 7 I retire a further 116 card bonds (national debt) – buying back 171 card bonds from my kids but selling 55 card bonds to the China Family. I note that the foreign component of this debt is falling too. Good! Even though this debt is denominated in my cards, I read that foreign debt would force me to default more quickly than locally-held debt. It didn’t make sense, but then who was I to question.
In Month 8 I retire a further 177 card bonds (national debt) – buying back 222 card bonds from my kids while selling only 45 card bonds to the China Family.
At the end of Month 8, national debt is at 55 card bonds down from the unsustainable level of 904 at the end of Month 5. My kids now hold 270 card bonds and the China Fmaily 282. More work is needed.
I don’t make the connection that the budget surpluses are forcing my kids to increasingly dis-save and run down their wealth to stay solvent. All I am motivated to do is to get the debt monkey of my back.
If I had have stayed reading billy blog I would have known that:
- The reductions in outstanding public debt is systematically reducing the income-earning opportunities for the kids. So not only does the austerity plan reduce employment opportunities it also erodes private fixed-income capacity.
- The budget surpluses continue to destroy wealth by squeezing the private sector of liquidity.
- Some kids will be becoming increasingly indebted.
- The introduction of a trade deficit doesn’t alter this result.
Month 9 – National debt falling, private (kids’) sector insolvent
In Month 9 I make further cuts in my wage spending to really drive down national debt. I want to push the net exports position into surplus and stop the foreign debt rising and I want to extinguish all locally-held public debt.
That idiot on billy blog starts accusing me of being a “deficit terrorist” – but what would he know anyway?
Anyway, the austerity plan continues and I cut my wage bill to 310 cards per month and my interest payments on outstanding public debt fall to 55 cards.
The exchange rate is starting to appreciate as the trade balance narrows and the IMF indicated this was a desirable growth strategy. Problem is that total house economy income (GDP) has fallen further to 330 cards and there is no longer much work being done around the house. The garden is in a sorry condition and rubbish is piling up. Moreover, some of my longer term projects – I called them public infrastructure development projects – like painting the house are now abandoned.
But this is all temporary – that is what the message from the mainstream economics writings is. Clearing out the debt and getting the deficits down will pave the way for growth.
My budget surplus is now a wonderful 235 cards but needs to be higher because there is still outstanding national debt.
The kids now dis-save a further 270 cards (their total income is 330 and they have to pay 600 in taxes). They get the shortfall by selling me back their bonds. It just happens that they had exactly 270 card bonds left so I have retired all locally-held national debt. That is a cause for me to call another family meeting, rather like going on national TV, and announcing that:
The household economy has now retired all its locally-held debt. We will not have to pay higher taxes to pay the interest servicing payments and now we are running surpluses, the deficits have all been paid back too.
The kids look at me with a distant gaze – they seem troubled by this news – I don’t realise they are now underemployed and insolvent.
For next period, they will default on their tax obligations given they have no sectoral wealth left and they cannot earn enough income to cover their obligations. I tell them that they will have to work for less card income if they want to get more work. They wonder how that will work when I am still only paying 310 cards per month and expecting 600 back!
I also note that the current account is heading into surplus (a small deficit remains) which will allow me to start retiring the foreign-held national debt. Before long our household economy will be debt-free, running external surpluses and will continue to run budget surpluses. Everything that the design of the credible exit plan I read in countless articles specified.
I just have to convince the kids to save more so they can pay their taxes in the coming months. I have done as much as I can to get the tax and interest payments monkey off our backs!
But more can be done and I start to read about Greece and the need to avoid sovereign default on outstanding held by the China Family. More fiscal austerity is called for.
If I had continued to read billy blog I would have realised:
- The accumulated budget balances equal the accumulated savings in the non-government sector. The distribution of these accumulated savings between private domestic and external depends on the size of the external deficit. The prior local accumulated saving was achieved by cumulative budget deficits and the external deficits. The budget surpluses destroyed the private wealth and offset the earlier deficits (which had created private wealth).
- Running surpluses thus forces the private sector to dis-save and private wealth holdings are destroyed as a consequence.
- For a time the kids were able to borrow from each other to maintain their spending (and tax payments) but eventually, their saving is compromised by the falling national income (household wages plus interest payments). The fiscal austerity in each of the last 4 months causes recession and increasing unemployment and ultimately mass insolvency in the private sector.
Sectoral balances – another perspective
The following graph shows the sectoral balances from the Table to allow you to understand the relationships more clearly. You can observe the different stages of budget dynamics.
These balances are derived from the National Accounts and in summary (in our simple model without private investment) the condition that has to hold is that:
S + (T- G) – NX = 0
So private saving (kids) plus the budget surplus minus the external surplus has to sum to zero. It is easy to see that
S = -(T-G) + NX
So if the public balance is in surplus and there is an external deficit (NX < 0) then S must be negative by construction of the national accounts. You cannot escape that conclusion. In this example, we have seen how a wilfully designed fiscal austerity program in the presence of a current account deficit systematically undermines private saving.
At the outset, with a balanced budget and no trade, there is also no private saving overall. All income is being taxed away. As the business card deficits expand, the boost to total income allows the kids to save from month 2 at a steady rate. Note the graph is showing flows per month. In months 2 and 3, saving is 200 cards per month (a flow) which accumulate after month 3 to 400 cards of assets or wealth (a stock).
In Month 4, the neighbours arrive and imports rise faster than exports and so the kids are spending some of their income outside the economy which reduces their saving and the total income available. The net exports (current account deficit) rises but private saving is still strongly supported by the budget deficits.
Then the fiscal austerity program begins and the negative impact on total income is such that private saving now plummets in the negative zone. The current account deficit narrows as imports are hit hard (they are a function of total income). The kids can only meet their tax obligations now by selling up their bonds and using the liquidity to meet the shortfall.
As the fiscal surpluses continue to ravage income, the kids continue to dis-save. By Month 9, they have no wealth left and cannot pay their bills. They are broke and the system grinds to a halt with massive unemployment and poverty.
You can see that when the neighbours moved in certain distributional changes occured in the accounting relationships and the situation became more complicated. But the basic principles summarised by the sectoral accounts remain intact.
I could have extended the model to have a period of external surpluses. If they had have been large enough then private saving could have been supported even though the public budgets were in surplus. This is the Norwegian case. But very few nations are in this situation. Most of the nations are in the situation presented in this model. Current account deficits are the norm.
This typical model allows you to see that under these normal circumstances, budget surpluses undermine income generation, reduce the capacity of the private domestic sector to work and save, and destroy the wealth holdings of the latter. Ultimately this sort of strategy will generate insolvency and crisis.
The introduction of the next door neighbours should also dispel any notions that the “closed economy” version of this model was hiding something important. It was not. The sectoral balances are very clear when you add the external sector.
Further, you should be able to clearly understand that the China Family is not funding the public spending in this model. How can it? I issue my own business cards and they issue their cards. I spend in my cards.
Further, I don’t need to sell any bonds. All that would be different is that the bond holdings rows (local and external) would be zero and the cash holding rows would record the asset accumulation. Should either the local kids or the China Family kids not want to hold this cash then they could spend it in various ways and this would reduce my deficits anyway and help support growth and income generation.
I have also conducted this in real terms. It wouldn’t make much difference if I did it in nominal terms with a price level incorporated. In the growth phase as long as capacity was growing then inflation would not have been an issue and in the recessionary phase, deflation would likely occur and make matters worse.
But the underlying sectoral relationships and the budget-driven dynamics shown here would all still occur.
Most of the so-called experts who care to wax lyrical about exit plans and national debt never reveal they understand anything about these sectoral relationships or budget dynamics. Most of what they say would never “add up” nor is it stock-flow consistent.
What this simple model allows you to do is see the basic relationships clearly and how the spending, income and saving flows in each period impact consistently on asset stocks held. You will find very few mainstream economists who will entertain that level of consistency in their analysis.
In addition to the background reading I suggested above to map this model into the real world I would recommend you read the following trilogy: Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit spending 101 – Part 3.
That is enough for today!