Bernanke on financial constraints

The US program 60 Minutes interviewed Fed Reserve Chairman Ben Bernanke at the weekend. The interview is largely a litany of mainstream statements but at one point the Chairman gives the game away to the interviewer Scott Pelley. Apart from Bernanke’s very clear statement about how governments actually spend, the interview reveals the confusion that the top banker has with the way the modern monetary economy operates.

If you listen to the interview (the link will take you to the video and the transcript) you will realise that at around the 8 minute mark Bernanke starts talking about how the Fed (the US central bank) conducts its “operations” (in this case, how it conducts government spending).

Interviewer Pelley asks Bernanke:

Is that tax money that the Fed is spending?

Bernanke replied, reflecting a good understanding of what we call central bank operations (the way the Fed interacts with the member banks):

It’s not tax money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed. It’s much more akin to printing money than it is to borrowing.

So after getting the point correct that there is no financial constraint on Federal government spending (government spending is not financed by taxes) and that the Federal government spends by making electronic entries into accounts in the commercial banks things start to run of the rails. We then head back into the ga-ga land of the neo-liberals which bears no relation to the fundamentals of the modern monetary economy that we live in or that Ben Bernanke lives in.

So, Pelley then asked:

You’ve been printing money?

Bernanke replied:

Well, effectively. And we need to do that, because our economy is very weak and inflation is very low. When the economy begins to recover, that will be the time that we need to unwind those programs, raise interest rates, reduce the money supply, and make sure that we have a recovery that does not involve inflation.

Sorry, the central bank is always printing money (notes and coins) to meet our circulation requirements but this has nothing to do with government spending. Read Bernanke’s first response to be clear on how governments spend.

Is what the Fed is doing good for employment growth? There is a fundamental difference between government spending on goods and services and the “quantitative easing” that the Fed in the US is engaging in. What the Fed is doing is exchanging balances in reserves (creating them in the banks) for financial assets that the banks are holding. The Fed is not out there buying goods and services directly from employers who would then employ people to make them.

In this sense, the Fed is only exchanging financial assets with the private banks and as I explained in my Quantitative Easing 101 blog the only way this might stimulate aggregate demand is if the lower interest rates (on the longer-maturity assets) encourage investment. Countering this effect is the loss of income from savers as the returns on assets fall. Net effect: uncertain, but could be zero.

The situation is somewhat different when the government buys goods and services. Here the government credits accounts in the commercial banks in return for the transfer of goods and services from the non-government sector to the government sector. The important difference is that the spending goes straight into aggregate demand and firms have a direct incentive to maintain and increase employment levels in response to the growing orders.

As an aside, some people are confused about the coincidence of tax revenue and government spending. Does the former “finance” the latter which is what it looks like?

The answer is no – governments can spend without the tax revenue. What the tax liabilities do is reduce aggregate demand in the private economy so that the government can have “space” to buy the unsold output and use the purchased goods and services to pursue its socio-economic program (its “mandate”).

Another way of thinking of this, which is slightly more lateral is to consider the following.

The purpose of government spending is to move real resources from private to public domain to facilitate the government’s economic and social program. As government spending is not revenue-constrained, 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 and fulfil net savings desires. So by design tax impositions can be said to create unemployment (people seeking paid work) in the non-government sector, while government spending reduces the unemployment as it satisfies the need for funds created by the tax liabilities.

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 unable to find a buyer at the current money wage. In the absence of government spending, unemployment arises when the private sector, in aggregate, desires to spend less of the monetary unit of account than it earns. Nominal (or real) wage cuts per se do not clear the labour market, unless they somehow eliminate the private sector desire to net save and increase spending.

Digression: Executive bonuses

It has been reported that the failed insurance company AIG, which is effectively state-owned now after the massive injection of US government funds to keep it afloat, last week paid bonuses of $US1 million or more to 73 employees, including 11 who no longer work there. These bonuses have typically been justified as being essential in order that the company retains its valuable and talented senior executives in a highly mobile and competitive market. Well I think the decline in AIG after taking massive and unconsciable risks put paid to the first bit – that they were talented and valuable. But now we learn that the payments that were agreed, presumably during hiring or renegotiation of contracts, did not actually retain the services of the executives anyway. They pocketed the cash and ran. So the real world – dudded again!

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    4 Responses to Bernanke on financial constraints

    1. Lefty says:

      So……..where to now the the Australian and global economy?

      If I have understood correctly, we have had a long period of economic growth, financed mainly by the perpetual expansion of private debt. But it seems that late last year, we ran into the limits of private debt expansion. So as an economic growth strategy, this is finished. Yet governments still appear convinced of the need to run up large budget surpluses. If government will not spend under these circumstances, how is growth to be financed?

      I think reality might dictate that defecits be a normal feature of future budgets for some time.

    2. bill says:

      Dear Lefty

      From my perspective the neo-liberal game is largely up. We are in the period of “paradigm shift” where the dominant minds of the past are still struggling to remain relevant. Their shrill objections to what is happening at present are the death cries of a past age. The fundamentals that drove the growth were never sustainable. Huge fiscal drag straining private wealth and disposable income; real wages basically flat while productivity growth has been relatively robust; thereby resulting in a massive redistribution of income towards capital; thereby necessitating the force-feeding of debt to the private sector (mostly households); and it was only a matter of time. It took a not longer than I predicted 10 years ago but only a few years longer for the whole thing to collapse.

      The future, if it is to be sustainable, and address world poverty, high labour underutilisation, climate change, and the degeneration of public goods will have to see private households return to saving overall and governments return to running deficits more or less permanently. The challenge is to push the debate in that direction now things have turned so sour for the neo-liberal self-regulation model.

      best wishes
      bill

    3. David says:

      Bill,

      Thanks for your posts on the deficit & debt processes of governments, I believe it might be slowly sinking in. A couple of questions:

      a) Can State Governments in Oz finance spending in the same way that national governments can – it seems to me they might be more like a ‘household’ than a sovereign government, because they don’t issue the currency and the money they require people to pay taxes in isn’t their own.

      b) are there any other economists you can point to make similar arguments about the monetary system and how governments can always finance their own spending? Commentators like Paul Krugman, Steven Keen or John Quiggan are clearly pro-deficits at this time, but I’m not sure what their views are on whether deficits necessarily leads to government debt.

    4. bill says:

      Dear David

      Thanks for your interest in the sorts of things I write about. It doesn’t matter how long it takes to sink in – just as long as it does!

      Answers:
      (a) The State government is more like a household in that sense. It is definitely not sovereign in the currency and has to “finance” its spending. That spending it cannot cover in taxation has to be covered with debt-issuance. But it is quite different to a household in another sense – it has a huge tax dragnet to draw upon and the likelihood of it becoming insolvent is low. That is why it can borrow to fund net spending (deficits) at much lower rates than the private sector – stay tuned for my Public Private Partnership blog later today. So there are limits on a state government can do. By the way, the Eurozone governments are all in this boat too having voluntarily given up their currency sovereignty to the ECB.

      (b) My colleague Randy Wray (University of Missouri, Kansas City) is a notable US economist who has written a lot about modern money. I am writing a macroeconomics text book with Randy at present to replace the mainstream trash that is typically provided to students in our universities. My friend Warren Mosler who is a US bond trader (of some repute) is also a modern money adherent and comes at it from his vast experience in money markets. Warren orchestrated the largest futures delivery to date (over $20 billion notional) in Japan in 1996 and he also created the current euro swap futures contract. So he actually works in the markets and trades government debt instruments for a job. See link to his site on the right menu (at the bottom). There is a growing band of economists who are starting to understand this stuff and advancing it in their own way. They are realising that some of the essential insights left by Abba Lerner (1943) in his paper ‘Functional Finance and the Federal Debt’, Social Research, Vol. 10, 38-51, which provide the underpinnings of the “real side” of our analysis, still have credibility. And when you couple them with a modern money view of flexible exchange rate currency monopolies, things start to make sense. When you are at your next dinner party, ask any neo-liberal you meet – how do you explain Japan over the last 18 years. Make sure it is after dinner so they don’t choke as they attempt to use their theories to explain it. They cannot!

      Paul Krugman is not a modern monetary economist but as you say does support deficits. I suspect John Quiggin is in the same boat but you might ask him. Steve Keen is not a modern monetary economist. I have had several interchanges with him (and know him well) about things and he keeps saying governments have to issue debt to fund deficits. No they don’t! They may issue debt at the same time they run deficits but the former is a monetary operation to defend target interest rates while the latter is a fiscal initiative which is not revenue-constrained. Coincidence is not causality.

      Hope that helps.

      best wishes
      bill

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