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Differing viewpoints on the role of debt in the economy

The following appeared within an article in the Jul-Aug 2014 issue of the ERA Review

The respective positions of the orthodox (neoclassical) and heterodox (mainly postKeyensian and MMT) viewpoints as they pertain to the role of debt in the modern economy differ profoundly, and may be summarised as follows:

Orthodox viewpoint

  1. The economy tends towards a stable equilibrium configuration.
  2. Private borrowing, spending and saving decisions are always driven by “rational expectations”.
  3. Banking and money flows don’t affect economic performance.
  4. Private debt growth does not affect economic performance.
  5. Public debt (deficit spending) must be minimised since it leads to rising inflation and rising interest rates. 

Heterodox viewpoint 

  1. The economy generally operates far from equilibrium.
  2. The idea of rational expectations is a fiction unsupported by evidence.
  3. Banking and the creation of new money by banks matter because they contribute to purchasing power and economic performance.
  4. Private debt growth (relative to GDP or a genuine progress indicator) must be restrained, because if excessive it will set the economy up for a crash.
  5. Sovereign government debt (aka Treasury securities) should be allowed to rise to whatever level is required for the operation of a healthy economy.


John Hermann

Is MMT irreconcilable with NCT and Sovereign Money?

It is unfortunate that the advocates of MMT (modern monetary theory) and various monetary reform movements including  NCT (new currency theory) and Sovereign Money misunderstand each other’s positions. There are important truths in each viewpoint, and I do not see a necessary contradiction between the main thrusts of their respective stories.

A very interesting paper published in Real World Economics Review [1] by Prof Joseph Huber – a primary advocate of NCT – takes MMT to task on several matters, even though he agrees with some of their analysis.  In my opinion Huber’s primary criticism of MMT is unjustified and the assertions and arguments he has given in this regard are flawed. To critique Huber’s paper  in detail would require considerable effort, however I would like to draw attention here to one section where his assertions struck me as being obviously incorrect.  Let me quote the section:

“ Don’t let yourself be fooled. The biggest part of government expenditure is funded by taxes. Tax revenues represent transfers of already existing money. The money that serves for paying taxes is neither extinguished upon paying taxes, nor is it created or re-created when government spends its tax revenues. In actual fact, this is all about simple circulation of existing money. “

The MMT position that the government injects new money into the real economy when it spends, and withdraws money from the real economy when it taxes and borrows, implies that Treasury’s general account with the central bank (CB) is not actually composed of money at all and is therefore merely an operating account.

This rings true because it is not difficult to see why the credits held in Treasury’s general account cannot be regarded as money, in any sense of the word.  One of the characteristics of an entity which is entitled to be called “money” is that it is used by a set of marketplace players and may be loaned and transferred between those players.  Thus, for example, the credits that banking institutions maintain within their CB accounts (reserves, or exchange settlement funds) must be regarded as a form of money because – apart from satisfying the usual criteria of medium of exchange, store of value, and unit of account – may be loaned between those players and directly transferred between their respective CB accounts.  However the credits held within Treasury’s account with the CB are never loaned out or transferred to any other institution under any circumstances.  When the central government spends, new bank credit money is created by the payee’s bank and matching new reserves are created in that bank’s CB account.  Reserves are not transferred, because the definition of reserves excludes Treasury deposits.

[1] <>

John Hermann

Federal government deficit spending

Recent articles in The Conversation * reveal that the Australian federal budget deficit is increasing, for a variety of reasons discussed in those articles.  Moreover it is becoming abundantly clear that there is no possibility of having a balanced budget within the forthcoming decade, let alone a budget surplus, notwithstanding the insistence of the Treasurer, the Finance Minister, and the senate leader that a budget surplus remains their ultimate objective.

To quote Ross Guest, Professor of Economics at Griffith University,

“The MYEFO only confirmed that the Treasury and government accept what we’d already been told by independent experts: the federal government budget is shot. There is no prospect with the current level of taxes and array of spending programs of getting spending and revenue back into line within a decade and probably longer.”

But none of the authors listed in these articles seems to think it is appropriate, in a contracting economy characterised by increasing levels of poverty and unemployment, for central government spending to exceed the aggregate of taxation receipts. This view is grounded in their a priori belief that deficit spending is necessarily inflationary and will put upward pressure on interest rates. And it is obvious that the choice of “experts” in the multiple author article was taken exclusively from the ranks of neoclassical economists and business economists.  A more balanced selection of the views of “experts” would have included informed contributions from economists like Prof Steve Keen, Prof Geoff Harcourt, and Prof Bill Mitchell.

A lot of confusion and misunderstanding surrounds the topic of borrowing by a currency-issuing central government (CICG), which is the basic mechanism by which government deficit spending is accommodated.  Treasury securities (i.e. bonds and bills) issued for this purpose are in many respects as good as money, and short term securities are often referred to as “near money”.  The Australian federal government has an unlimited ability to create these financial instruments, just as the central bank (RBA) has an unlimited ability to create state fiat money (consisting of currency and reserves).  Treasury securities and state fiat money may be regarded as interchangeable financial entities.

It is essential for understanding the associated monetary mechanics to recognise that when a CICG deficit spends it increases the liquidity ** of the private sector, and that this increase in liquidity is transferred to the community at large. The liquidity of banks and large institutional investors does not change substantially as a result of deficit spending. All that happens in regard to the latter is that one financial asset (Treasury securities) is exchanged for another financial asset (credit money plus reserves).  However the receipt of this money by Treasury then authorises the central government  to spend an equal quantity of money into the real economy. The net result is that the liquidity available to the private sector as a whole increases by this amount.

Incidentally, it is not even remotely valid to assert that the interest paid out on Treasury securities (notwithstanding that interest is a budgeted item) is paid from tax receipts.  Thus, in a normally operating and growing economy – where the stock of Treasury securities is growing in tandem and at the same rate as the rest of the economy (which must of necessity be the case if the economy is to be sustainable and to prosper) – the interest payments may be viewed as being effectively factored into the ongoing issue of new securities.

Moreover, the creation of CICG Treasury securities (aka public debt) may be regarded as equivalent to the creation of new money, by virtue of the fact that the central bank can buy back any of these securities from the private sector at any time the private sector (including the banking sector and the general public) requires more currency and/or credit money.  The net outcome of such buybacks by the central bank is the financial equivalent of the government selling Treasury securities directly to the central bank – which some people wrongly describe as “printing money”.


*  The Conversation, 15 Dec 2014

  1. Michelle Grattan article, “Government reveals $40 billion budget deficit, clings to surplus hope”
  2. Multiple authors, “Federal budget deficit climbs to $40.4bn: experts react”

**  “Liquidity”  is the conjunction of useable money and any other high quality financial assets which may be readily and speedily exchanged for money.

John Hermann

ERA submission to the Financial System Inquiry

The following is a short submission made by ERA to the Australian Inquiry into the Financial System (FSI), and can be found in the public document containing all of the submissions.

The Chairman
Australian Financial System Inquiry

Dear FSI chairman,

Economic Reform Australia (ERA) is responding to the second call for submissions in regard to the Inquiry into the Australian Financial System. There are several aspects of modern banking operations which concern our association, and these concerns include those listed below:

1. The “too-big-to-be-allowed-to-fail” aspect of modern banking is well recognised by well informed economic opinion to constitute a threat to democratic institutions and good government. We share this view.

2. We regard the “bail in” proposals which are currently being lobbied for by powerful banking interests as an unacceptable practice and breach of trust for depositors, who expect security for their deposited money. If governments were ever foolish enough to allow banks the privilege of either commandeering or directly lending out any part of their retail customers’ deposits (and especially transaction deposits), then they would (a) expose the banking system to great additional risk and eventual collapse, and (b) ensure abandonment of the conven-tional banking system by the public in droves, with the strong likelihood of alternative depository systems being set up. In other words, we would lose the banking system, as the public currently understands it.

3. It is important for the sake of financial stability to maintain a firm demarcation between retail banking operations and investment banking practices. And although we support the reasoning which underpins recent proposals for ‘ring-fencing’ of the trading operations of banks from their retail banking operations we prefer to go further than this. Simple ring fencing allows inventive financial manipulations under the cover of the financial institution’s operations. Thus regulatory oversight would be limited to the capability of the regulators and their capacity for oversight — i.e. their ability to access all relevant information, which in reality is not possible. It is much better to fully separate the two functions, along the lines of the original Glass- Steagall Act (first implemented in the U.S. in 1933).

4. We also believe it would be in the interests of greater financial stability to oblige banks to hold more regulatory capital – in relation to their risk-weighted assets – than is allowed for under current BIS arrangements.


Economic Reform Australia
25 Aug 14

Mainstream economists do not understand banking

The following quotes from some eminent heterodox economists and leading central bankers reveal that they understand something  about the nature of banking which we know is simply denied by many mainstream economists. Namely, that banking institutions around the world create new credit money in the process of advancing retail loans, as well as when they buy goods and services from the non-bank private sector.

Moreover, as has been pointed out on many occasions by ERA patron Prof Steve Keen, the change in net debt arising from bank lending makes a significant contribution to the change in aggregate demand.

The fact that so many neoclassical economists have failed to grasp these important aspects of the mechanics of modern banking, as well as the reality that money creation by banks occurs endogenously (rather than being under the direct control of the central bank, as many mainstreamers seem to assume) is nothing short of a major intellectual scandal. And their ignor-ance of the underlying mechanics of banking is hindering their ability to adequately analyse and deal with the world’s pressing economic problems.

The previous issue of ERA Review (March-April 2014) contains two excellent articles, by Steve Keen and Geoff Davies, which flesh out the abysmal failure of the economic mainstream to reappraise their theoretical models in the light of their inability to predict the financial crisis of 2007-8.  And with very few exceptions, their second failure has been their inability to take a big bite of humble pie, a necessary precursor for bringing their models into alignment with the basic realities of banking as understood by central bankers.


The process by which banks create money is so simple that the mind is repelled.

John Kenneth Galbraith  –  Economist

Banking is not money lending: to lend, a money lender must have money.

Hyman Minsky  –  Economist

Of all the many ways of organising banking, the worst is the one we have today.

Sir Mervyn King  –  Former Governor, Bank of England

In the real world, banks extend credit, creating deposits in the process, and look for the reserves later.

Federal Reserve Bank of New York (1969)

The financial crisis of 2007/08 occurred because we failed to constrain the private financial system’s creation of private credit and money.

Lord Adair Turner – chairman Financial Services Authority

John Hermann

A Government Surplus is a Private Sector Deficit

It is well known in economics that the net sum of private, public and foreign sector balances is zero. Thus if the foreign sector is equally balanced by imports and exports, then a federal government deficit implies a private sector surplus. Likewise if the government aims to go into surplus, it must remove money from business, industry and households through increased fees, taxes, etc.

A private industry surplus (public sector deficit) is good policy because it allows further development and expansion and the economy can grow. Thus, arguably, the federal government should always aim to run at least a small deficit. Running a deficit means the government spends more than it receives from taxation, and the net result is that the private sector’s savings (financial wealth) increases. This allows more investment and growth in national income. But if the government runs a surplus, income to the private sector is reduced, thus reducing its ability to purchase goods and services and to finance desired business plans, and so national income falls.

If the private sector reverts to financing its plans through increased debt, sometimes on the assumption that its assets will continue to increase in value (as it did in the decade prior to the Global Financial Crisis), then in the short term productivity and employment will increase, the government will possibly go into surplus (at least temporarily), and the government of the day will bask in glory, as we have seen and continue to see today.

But this debt is fundamentally unsustainable: last-minute financial restructuring and panic debt swaps inevitably produce a dramatic collapse and surpluses are invariably followed by recessions. This process has been spelled out in many well-informed publications, including those of Economic Reform Australia.

Recalling the glory days of a government surplus is mischievous in the extreme, for those days, if repeated, will result in the same disasters that we have seen in the past.

Government surpluses must be generally avoided. Government deficits will always be necessary on average, if we are to grow and avoid similar crises in the future.

Darian Hiles

Aspects of modern monetary theory


      Following the advent of the global economic crisis, there has been a growing recognition and understanding of the claims made by a relatively recent school of economic thought known as Modern Monetary Theory (MMT), which is a development of what used to be called Chartalism.  Considering that there are ongoing economic crises within both Europe and North America which relate directly to the issues addressed by MMT, it seems timely to look at some of MMT’s claims and how an MMT perspective might assist in resolving those crises.  Firstly we will review money and government debt. 

Two types of money

There are two widely used forms of money: (a) State fiat money, which is money created by a sovereign monetary authority (usually a central bank) and acceptable for  the payment of taxes. The main forms being currency (coins & notes, which have been declared to be legal tender) and creditary banking reserves (exchange settlement funds); and (b) Bank credit money, which is money created by commercial depositories (banking institutions) as retail deposits, and exchangeable with legal tender.

There is an important subdivision of state fiat money, known as banking reserves, which is the conjunction of currency held by banking institutions and their deposits in the central bank.  The two components of banking reserves are interchangeable.  Currency held by the public is usually referred to as currency in circulation.  

Central (sovereign) government debt

A government which is economically sovereign creates and issues the currency used by its citizens.  And traditionally it also creates and issues  securities, which are instruments of debt sold to the private sector on the open market.  When government securities are sold to the non-bank private sector, money is extracted from the economy in exchange for another (generally liquid) financial asset, so that the financial wealth of the private sector remains unchanged.

MMT asserts that such public debt is fundamentally different to private debt, in that it is always possible for a government which issues currency to roll the debt over – in perpetuity – and to pay any interest due on that debt. According to MMT there is no constraint, at least in principle, on the ability of a sovereign government to effect such payment.  For a sovereign government there is no “central government debt problem” as such, the latter term indicating a misunderstanding held by those with a poor understanding of macroeconomic principles.   

Spending, taxing and borrowing

Contrary to what many neoclassical economists believe (and would have others believe), a sovereign government engages in taxing and borrowing only ostensibly for the purpose of raising revenue.  Although central governments behave as if taxing and borrowing is undertaken in order to raise revenue, the MMT interpretation is that this is not what really happens.  Thus government does not need to raise revenue for the purpose of funding specific cost items, because new money is injected into the economy whenever it spends.

Spending introduces new money into the economy, while taxing and borrowing remove money from the economy.  Although at first sight there might appear to be a chicken-and-egg relationship in these fiscal flows, MMT asserts that the causal relationship is for spending to come first, and for taxing and borrowing to follow.  If this relationship postulated by MMT is accepted, then it follows that the real and largely hidden purpose of taxing and borrowing is to recapture the money which a central (sovereign) government spends into the economy, in order (a) to keep a lid on inflation, and (b) to ensure that money moves around the economy with sufficient velocity.  

Central government and the lower levels of government

The lower levels of government (state, provincial and municipal) do not issue their own currencies and – in Australia at least – do not impose income taxes on those whom they govern, although they are accustomed to imposing a range of other taxes, duties and levies.  Their fiscal constraints are therefore quite different to those of the central government.  A lower level of government – in common with the private sector – is obliged to be more careful in its budgeting than is a (sovereign) central government, which may safely run a budget deficit in perpetuity (and arguably should do so, according to MMT ideas).

Deficits are the norm

A graph of the U.S. federal budget balance over 82 years (care of a blog by Bill Mitchell — reveals that  budgets have been in deficit for around 85% of the time.  In other words, deficits are the norm and surpluses are the exception.  I suspect that much the same picture would emerge with a more extended time-span.  The history of budget balances indicates that the oft-held belief that running a sequence of budget deficits will have dire inflationary consequences for the economy is not grounded in reality. And MMT advocates insist that any drive to achieve a budget surplus in circumstances where there are idle resources and reduced aggregate demand is economic vandalism, because it leads to unnecessary austerity and can only hinder economic recovery.

Accounting conventions

Banking operates according to a set of accounting conventions, which are rules designed to match the receipt/loss of a certain type of asset by a banking institution (depository) with the receipt/loss of a liability of equal magnitude.  The asset of particular concern is newly created bank credit money, which arises when a bank advances a new retail loan or when a cheque drawn on the central bank is deposited.

It is generally held by economists that banking reserves should be regarded as central bank liabilities.  On the other hand, it may be argued also that it is inappropriate to attempt to make a central bank, as the creator and destroyer of state fiat money, conform to the accounting rules which apply to commercial banks.           

Central government’s account with the central bank

Every central government maintains one or more accounts with its central bank.  In Australia for example the federal government does its banking with the Reserve Bank of Australia (RBA).  Thus the cheques written by an Australian government department are drawn on the RBA.  The situation in New Zealand is a little different, as revealed by the following statement found in a part of the RBNZ website (

”  Although the government ultimately does all of its banking with the Reserve Bank (via its Crown settlement account, or CSA), it uses an account held at Westpac for its transactions with the public.  That’s why payments from the government, e.g. unemployment benefits, are paid using Westpac cheques. The transactions in this account are totalled up and the balance is transferred to the CSA at the end of the banking day.  ”

The general account of a central government with its own central bank records in monetary terms the government’s various fiscal operations – specifically spending, borrowing from the private sector, tax receipts, and all other receipts.  When a central government spends, its general account is debited accordingly.  And when it borrows from the private sector or acquires tax (or other) receipts, its general account is credited accordingly.

There is general agreement that central government spending entails the creation of new retail demand deposits and an increase in the money supply (as measured by the monetary aggregate M1), while central government borrowing, taxing and the receipt of other income entails a reduction in the money supply.  A more interesting issue is the fate of the banking reserves, which generally tag along with retail deposits in the broader economy.  While the precise mechanics differs from country to country, in each case there exists some combination of (a) immediate removal of those reserves, in exchange for an increase in the government’s general account, (b) use of the reserves to temporarily purchase highly liquid (risk free) financial assets, and (c) use of the reserves to temporarily create deposits in commercial banks (which deposits, however, lie outside the money supply M1).  Items (b) and (c) are holding options, and those reserves are retrieved in a piecemeal manner as and when required according to the need to offset government spending operations, once again involving the removal of those reserves whenever the general account requires to be increased.  The practice of maintaining holding investments and/or commercial bank deposits exists only for the purpose of regulating (minimising fluctuations in) the volume of banking reserves during the course of a financial year.    

Are government deposits in the central bank money?      

The economic mainstream hold that government entries or “deposits” in its own central bank account are a form of state fiat money, moreover one which is interchangeable with reserves.  There is an alternative viewpoint, which is consistent with MMT ideas, which holds that such “deposits” are not money in any real sense of the word, but are merely accumulated credits in an operating account.  An operating account records a financial reality, but it does not need to be regarded as a form of money.  The rationale for this perspective is:

(a) One of the essential requirements of any entity which acts as money is that it is used by (traded, loaned and borrowed between) a sufficiently large number of marketplace players who have similar status and objectives in regard to those operations.  Banking deposits in the central bank satisfy this criterion, since all of the players are in competition with each other with the common objective of maximising financial profit.  In contrast, a central government maintains an account with its central bank for a quite different purpose, and its spending has a different objective, to that pertaining to commercial banks; and

(b) There are other examples within the financial system of accounts which are not regarded as being stores of spendable money, such as commercial banks’ internal operating accounts.

On this basis it may be held that the central government stands alone – that is, not in competition with any other entities possessing accounts with the central bank. Indicators of this difference lie in the fact that a central government sells bonds but never needs to buy bonds, and also borrows money but never needs to lend money.  If all of this is held to be true then arguably the entries in the government’s general account are not money.

John Hermann



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