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Paying for public services, in a monetary sovereign state

If our national Government was to spend more than the currently budgeted amount on your health care system next year, it would be good to know how they would finance that spending. It is a question that advocates of more health spending are always likely to be asked. More generally, exactly how is the total public spending which is currently budgeted for across the next year going to be funded? Do the various charts you see, linking the total tax take and government borrowing to items of government expenditure make any sense? If not, then why not?

The conventional view is that public spending must be paid for through taxation, government sales of assets, or issuing government bonds – in other words, through taxes now, ‘selling off the family silver’ now, or borrowing at interest now money which will have to be repaid in the future, and presumably setting up a burden of additional tax-ation for future generations.

Your reaction to this conventional answer might be a “conservative” one, which is to say, austerity to keep government spending down and privatisation, in order to keep taxes low: or a “progressive one”, which is to say, tax the rich and the multinationals much more highly, because the Government needs more money from rich people so it can pay for our public services.

Both of these reactions are wrong, or at least misleading, because they are based on that conventional view of public sector finance which I mentioned above. It is a conventional view which suits many conservatives, but is also (wrongly) accepted as being valid by many progressive people. It is – and this might surprise you – a view which the majority of highly credentialed economists, including Nobel Prize winners, know to be incorrect, but which many of them justify as a mechanism for imposing some restraint on politic-ians. They believe that if politicians only knew the financial options which are actually available to them, they would abuse these freedoms, ‘spend like drunken sailors’, wreck the economy.

I don’t believe there is ever a good reason for remaining in ignorance about something this important, and I think we have other ways of restricting what politicians do than telling blatant lies to the public, so I want to share the truth with you.

To keep this as brief and as straight-forward as I can, I am not going to dwell on the current institutional practices, conventions and rules, as they are applied in 2016. Current practices are very different indeed from how things were done before 1979. All the sets of conventions and rules which have been applied down the years have, to a greater or lesser extent, obscured the truth about public finance, which I can summarise in two sentences. Let’s call them two ‘laws’ of public finance (based on Lerner’s laws of functional finance, from the 1940s).

1 A government with its own currency (like the dollar), its own central bank (like the Reserve Bank), a floating exchange rate, and no foreign currency debt, faces no financial budget constraint at all.

2 Such a government faces real and ecological constraints, but no financial constraint.

Let’s be clear what we are talking about here. We are not talking about Greece. We are not talking about an independent Scotland, if Scotland were to keep the pound or join the euro (which I have recently advised a Scottish political party to stop saying they would do). We are talking about a genuine ‘monetary sovereign’. We are talking about the USA, Japan, Australia and the UK, among many others.

The Australian Government is a monetary sovereign. Every time the Australian Government spends a dollar, it does so by crediting the reserves of a commercial bank which are held at the RBA (Australia’s central bank) by that dollar, and having the commercial bank credit the bank account of whoever has been the beneficiary of that spending. In other words, every time the Govern-ment spends, it creates money. Not some of the time – every time. All of the Governments spending creates money, and all this money is created using the equivalent of keystrokes on a computer.

The Government does not need to receive your money in taxes, or borrow your money by selling bonds, or raise money from you by selling you shares in government owned utilities …. before it spends. Think about it for a moment. It isn’t, in a literal sense, your money in the first place. Who issues the nation’s currency? The RBA. And who owns the RBA? The Australian Government. The Government doesn’t need to collect its money, which it creates, from you before it can spend.

Every time our national Government spends, it creates some of its money for the purpose. I know commercial banks create a great deal of deposits for themselves, and a great deal of what is normally defined to be ‘the money supply’ by lending to their customers, but they can only do this because they have access to Government money, in the form of their reserves at the RBA. There are two ways for this money to be created. One is the Government spending this money (permanently) into existence, and the other is the RBA lending this money (temporarily) into existence.

We have come to the answer to our initial question. How can we pay for an increase in health spending? The same way that we pay for all public spending. The Government will spend the money into existence. The way the accounting is done these days, and current institutional practices, obscure this truth, but they do not change the fact that it is a truth. It is not a theory. It is a plain fact.

Let me put it more simply. Money does not grow on trees. It is easier than that. Money comes from nowhere. It exists mainly in the form of electronic entries on spreadsheets (these days), and you can say it is typed into existence. Our Government can no more run out of dollars than the scorer at a cricket ground can run out of runs, perhaps something to remember the next time our Australian boys go over to England to win the Lords’ test match. In this sense, the Government really does have a ‘magic pudding’.

You might ask me whether I am talking about ‘printing money’ to pay for the Government’s spending. You might conjure up visions of Zimbabwe or Weimar Germany. I’ll deal with those briefly in a footnote below, but let us be clear – in a sense, all of Government’s spending always involves ‘printing money’. Except, I hate using that term, because of its associations, and because it is a little misleading. Very little modern money is actually printed, remember – it is nearly all electronic.

The question is, then, why do govern-ments tax people at all? Taxes do not ‘pay for government spending’, after all. Taxes do not pay for the education service. Taxes do not pay for Medicare. It might make you feel better to know that your taxes are not paying for military weapons. They really aren’t. The Government doesn’t need to get money from rich people before it can spend. Your taxes, in a literal sense, do not pay for anything. Taxes, at least in a monetary sovereign state, pay for nothing at all. 

So, why do we pay taxes? There are many distributional, or microeconomic, functions which the tax system fulfils. However, at the macroeconomic level, the purpose of taxation is very simple. It is necessary for people to pay taxes to destroy (to use a provocative word) some private sector spending power, to make room within the economy for the government to conduct its desired spending on public goods and services, without pushing total spending in the economy beyond the productive capacity of the economy and causing inflation. Taxes limit inflation, helping us to maintain the spending power of money, so that people maintain their confidence in the value of money.

We have reached the second law I wrote down above. As a society, we cannot run out of dollars, but we can run out of people, skills, technology, infrastructure, natural and ecological resources. There are limits – but the limits are ‘real’ and not financial. When planning for the future, governments should use their freedom from financial constraints to plan wisely to manage the real and ecological constraints which will always be with us.

The Government, then, cannot spend without limit, because it would push total (private sector plus public sector) spending beyond the current capacity of the economy, and be inflationary. So we have to pay taxes.

This does not, however, mean that governments need to ‘balance the budget’, or should ever attempt to balance the budget, or limit its deficit to a specific proportion of GDP. In fact, most Governments (including Australia) have hardly ever run balanced budgets or budget surpluses in modern times, and when they occurred they tended to be just prior to economic downturns. For example, there were very small and very temporary fiscal surpluses in the UK in the late 60s, the late 80s and the late 90s. The rest of the time, the UK Government has been in continuous fiscal deficit, since the early 1950s.

This is not only true for the UK – it is true almost everywhere, with almost all the exceptions being relatively small and oil rich countries, like Norway. In the case of Norway, what makes it possible for the government to run fiscal surpluses is not the ‘sovereign wealth fund’ you may have heard about. It is simply Norway’s consistently large trade surplus with the rest of the world.

Most governments most of the time historically have run budget deficits. This is essential, because if the rest of us want to build up our savings in dollars (including foreigners in ‘the rest of us’) it turns out the Government will be forced, one way or another, to run a deficit. A good deficit will prevent a recession from happening, and a bad deficit would be the consequence of a recession happening and tax receipts crashing while welfare payments rise, when everyone wants to save and not spend. To explain the logic properly would mean going into too much detail here, but believe me it is a mathematical (or accounting) fact of life.

Doesn’t all this mean the Government getting further and further into a burden-some ‘debt’, which future generations will have to repay, so that government borrowing is somehow immoral, and especially so if it isn’t to pay for investments in the future?

Not once you understand that monet-arily sovereign governments don’t and can’t really borrow in their own curren-cies, at all, in the conventional sense of the term. If you or I, or a business, or a local authority, borrow in dollars, then later on we will have to repay that debt and the interest on it, or we will go broke. We are (obviously) not monetary sovereigns. We face a financing constraint.

It is different for our national Govern-ment. I have already said that the Government spends new money into circulation, and then uses taxes to destroy some of that money so that there won’t be rising inflation. Ideally, the Government should spend more than it taxes, when it is running a deficit, to ensure that total spending in the economy is at the right level to maintain full employment. The total level of public spending, how it is divided up between public goods, and the structure of the taxation necessary to limit inflation, are then political issues.

Until the Global Financial Crisis, and before some central banks started doing quantitative easing, it was necessary for their governments to sell government bonds to more or less match government spending net of taxes, in order to keep control of interest rates. The reasons are a bit dull, but if you bear with me I will try to explain.

Interest rates in general depend on the interest rate banks charge each other when they lend each other money for liquidity management purposes for very short periods of time. A fiscal deficit effectively feeds cash reserves, or liquidity, into the banking system. In the past, it was necessary to remove those reserves again by selling government bonds, or this interest rate would fall below the level the central bank wanted it to be at. Banks with plenty of reserves of cash don’t need to borrow from other banks. Sales of government bonds were about keeping the supply of cash to the banking system limited to the right level to stop interest rates falling.

That’s all changed now – at least in the UK, the USA, Japan and the Euro-zone. The central banks of all those countries first cut interest rates to virtually zero, after the Financial Crisis, and then used quantitative easing to deliberately flood the banks with cash reserves, by purch-asing large amounts of (mainly govern-ment) bonds from the private sector. The so-called ‘bank rate’ is now not a rate of interest at which private banks lend to each other – it is now the rate of interest that central banks pay on the huge amount of reserves the commerc-ial banks have on deposit with it. Rather than seeking to limit those reserves, the central banks have been deliberately increasing them.

Yet the old practice of each government selling its bonds goes on. It is rather ridiculous at the moment, because as the governments concerned are selling new government bonds – in a convent-ional view, to raise money – their own central banks (which are owned by each government, remember) are kept busy buying those same government bonds second hand from the private sector, in order to increase the amount of money in bank reserve accounts. It’s very strange and anachronistic. Econo-mists like me view it as something of a muddle.

We have learned in recent years that there is no genuinely good reason for selling government bonds at all, if you are a monetary sovereign government. Indeed, it would be better to convert them into term deposits at the central bank, and to regard them as a form of money. 

After all, at the moment bank reserves held at the central bank are (in an accounting sense) Government liabilities, on which the central bank as part of the Government pays interest, but are not seen as Government debt: government bonds are also government liabilities, on which the central bank on behalf of the Government also pays interest, but they are seen as Govern-ment debt.

Moreover, if the central bank, as a part of QE, buys Government bonds from the private sector, it is just swapping one interest bearing government liability for another. No wonder QE doesn’t work! It isn’t ‘free money’ at all. It is basically swapping two very similar assets for each other. The private sector used to own Government bonds and receive interest. The private sector now owns reserves at the central bank, and still received interest.

Why would that arrangement act as much of a ‘stimulus’ for the economy? Why, indeed? To cut a very long story quite short:

1 When the Government spends it creates money.

2 When the Government taxes it destroys money.

3 Government ‘debt’ should not be thought of as ‘debt’ in the conventional sense at all. It is better thought of as a form of money.

4 The Government cannot run out of money, and as long as it doesn’t guarantee to convert its money at a fixed rate into anything it could run out of, it faces no financial constraints at all.

5 However it faces real and ecological constraints, because we can run out of people, skills, technology, equipment, infrastructure, natural resources, and ecological space.

6 The Government is NOT a household and NOT a business, and has nothing at all in common with a household or a business, where financial matters are concerned.

7 When progressives understand this and start framing their arguments in this light, I believe they will be able to argue their points far more effectively and persuasively, and free themselves from what are sometimes called ‘neoliberal dogmas’ (i.e. conservative and ‘new labour’ nonsense).

Understand all of this, and I think that it will change your perspective on many things. And ought to make you a great deal more confident when dealing with interviewers. If they approach you using the conventional view as a framework, remember that it is either because they have never really thought these issues through or because they are being dishonest for some reason (sometimes it is a mix of the two, and people can, of course, be dishonest with themselves, or at least suffer from cognitive dissonance). 

Footnote: Mugabe’s Zimbabwe and Weimar Germany 

Zimbabwe 2008  If you engage in a poorly planned and violent land reform, regardless of your motivation, there will be consequences. Zimbabwe’s govern-ment managed to wipe out its vital agri-cultural system, while at the same time alienating most high income country governments, and facing sanctions. The supply of food failed. The Government then (literally) printed vast amounts of money to buy non-existent food, and inevitably the price level sky-rocketed. Ever higher prices then led to ever more money being printed, so that at least the friends of the government and the army could be provided for. The result was hyperinflation. The lesson is that if you destroy the supply side of your economy and try to make up for it by printing loads of money, you will be able to create hyperinflation. Zimbabwe 2008 has no lessons for Australia 2016.

Germany 1923  Germany’s productive capacity had been destroyed by war and by the resolution of that war. In addition, Germany had been required to pay vast amounts of gold to its former enemies. The only way to obtain the gold was to buy it, using marks which could then only be spent into a German economy already on the brink of famine. There were some other issues, but it’s basically similar to Zimbabwe 2008. If you destroy the supply side of an economy and then print loads of money, you will push spending far beyond the productive capacity of the economy and create inflation.

Steven Hail

Try fiscal policy, stupid!

The Bank of England is actually finding it difficult to persuade investors to sell it sufficient government bonds to facilitate its planned bank reserve for government bond swap (sometimes called ‘quantitative easing’).

There is a problem with a lack of spending – not just in the UK, but throughout the high income economies, to a greater or lesser extent.

Yields (interest rates) on government securities are negative in some countries, and at record lows in others, such as the UK.

And yet governments still refuse to do what we know works, which is to SPEND more.

They are obsessed with the government as household myth.

And so central banks have to keep doing these desperate and ineffective monetary operations.

Everybody knows they don’t work. Central bankers know they don’t work. Only politicians and some of their more obstinate, head in the sand advisers, haven’t understood this by now.

And so we have more of the same, as they desperately try to convince a still over-indebted private sector to take on even more debt, and kick the problem further down the road.

This is a problem which is actually bigger in Australia than in the UK, and is nothing to do with Brexit, but of more immediate (and possibly medium term) significance than Brexit.

It doesn’t help that there is still at best a grudging and slight interest in these issues in the media.

Nobody is prepared to say that governments should be spending and investing more, and that there is no need to in the normal sense of the term ‘borrow’ to do so.

I recommend, as do many, a voluntary and equitable job guarantee scheme to eliminate involuntary unemployment, assist in regulating effective demand and inflationary pressure, and stabilise an unstable economy.

Right now, though, we also need more government investment.

Forget QE! It isn’t what people often describe it to be (‘free money’) and it doesn’t achieve anything worthwhile, even when performed on a record scale.

Outright monetary financing of government investment spending, done on a sufficient scale, would deliver.

Meanwhile, if you want a quick fix, just put some money into everyone’s bank accounts.

Easy to do.

And yes, UK Conservatives and Australian Liberals, you very definitely could afford to do it.

It might even make you popular, and right now would not be inflationary.

Steven Hail

What causes changes and fluctuations in the volume of money?

A New Zealand colleague recently drew my attention to the NZ Royal Commission into Monetary, Banking and Credit Systems (1956) [1], and in particular to clause 157:

” 157. The volume of money (on the Reserve Bank definition) is increased:

(a) When a customer of the Reserve Bank or a trading bank lodges, to the credit of his account, foreign exchange received from the sale of goods or services beyond New Zealand, from gifts or legacies from persons overseas, or from the proceeds of a loan raised with an overseas lender.

(b) When the Reserve Bank or a trading bank buys securities or other assets from an individual or firm and the proceeds are lodged to the credit of the seller’s account at a bank.

(c) When the Reserve Bank makes a loan to the Government or to marketing authorities. At first, the borrower’s deposits at the Reserve Bank are increased, and when this money is spent, the recipients may lodge part of it in their accounts at the trading banks and retain part of it in circulation in the form of notes and coin.

(d) When the customer of a trading bank draws on an overdraft limit granted by the bank and the recipient of his cheque lodges it to the credit of his account at a bank. ”

Clause 157 remains valid for modern world economies, however it does not discuss the dynamic nature of the money supply.  In particular, bank credit money is temporarily reduced from the money supply M1 whenever a non-bank makes a payment to a bank (including a loan payment, of principal or interest), and bank credit money is temporarily added to M1 whenever a bank spends into the real economy or purchases a financial asset from a non-bank.

In addition to the four modes of money increase listed above, M1 temporarily increases whenever a bank spends or buys assets from non-banks, and when the central government spends into the real economy.  And M1 is reduced temporarily when a central government receives tax receipts from non-banks and when it borrows from non-banks.

Moreover, we need to consider deficit spending by a sovereign government, which spending is directly associated with increases in liquid funds available to the private sector, and in particular to non-banks. It will be recalled that liquidity is defined as the conjunction of accessible money and financial assets which are readily convertible into accessible money. Much of the liquidity held by the private sector takes the form of risk-free financial assets, embracing both short-term and long-term Treasury securities. An increase in liquidity has profound economic consequences, contributing to aggregate demand, private sector income and savings, and employment.

So we have a complicated dynamical picture of money and liquidity being created and destroyed, the full import of which may be assessed by setting up a dynamic model of the entire economy, including most importantly the financial and banking sector. Prof Steve Keen’s models attempt to do this, in marked contrast with the economic modelling of mainstream economists.

John Hermann

  1. Reference

 http://ndhadeliver.natlib.govt.nz/delivery/DeliveryManagerServlet?dps_pid=IE17384058&dps_custom_att_1=ilsdb

 

 

Does the federal government’s “credit rating” need protecting?

Has everyone forgotten the role played by the ratings agencies in the global financial crisis? Have any of those responsible for the wrongdoing of those agencies been punished for their destructive activities? Absolutely not! They have been protected from prosecution for their crimes. The ratings agencies in question have no useful or constructive role to play in the world and should, at the very least, be closed down.

The very idea that a monetarily sovereign government (meaning one that issues its own independent currency and has a floating currency exchange rate) is at risk of default on the securities issued by its Treasury is quite absurd. The contrary examples that are provided by those who do not understand this reality are always of governments that are not monetary sovereigns.

 

John Hermann

Governments ‘too focused on budget cuts’ says Bernanke

An interview on 26 October by BBC economics editor Robert Peston with former Fed chairman Ben Bernanke [1] has revealed that the latter thinks there should have been a stronger fiscal response to the global financial crisis in most countries, rather than their obsession with budget cuts, which left central banks with the primary responsibility of trying to pick up the pieces and keep their economies functioning — despite the moral hazard attached to bailing out the banks with public money.

As chairman of the U.S. Fed during the crash and its aftermath, Bernanke is the most influential central banker of our age, and so his opinions on economic policy should be taken seriously.

What was not discussed in this brief interview was the alternative — which would be anathema to most main-stream economists — of allowing the failed U.S. banks to go to the wall with their shareholders wiped out, and nationalising those banks with the application of government guarantees for all existing bank liabilities and assets.

The money directed to recapitalizing the newly nationalised banks could be repaid to the central government Treasury over time from the banks’ profits, after which time some consideration could be given to re-privatising them.

The response of governments, and especially the U.S. government, to the next financial crisis will demonstrate whether any lessons have been learnt. We might not have much longer to wait, in order to find out.

1. Source: http://www.bbc.com/news/business-34641850

John Hermann

Could anything be more insane than for the human race to die out because we “couldn’t afford” to save ourselves? *

During the past year ERA Review has published various articles highlighting the possibility and desirability of funding essential public services and utilities entirely by government spending, rather than through market operations dedicated only to achieving corporate profits. This alternative to the current system used to be described as a mixed economy, long before major political parties succumbed to the pressure of neoliberal spin and decided to uncritically accept the self-interested recommendations of business and banking economists. The latter groups have never wasted an opportunity to inform us that there is no alternative to state support for corporations combined with austerity for the majority of our citizens (the TINA principle) at a time when corporate profits and corporate tax evasion have ballooned to record levels.

At present there exists, in Australia and other countries, considerable unused capacity for the production of goods and services. In such circumstances a monetarily sovereign government can make use of deficit spending in order to fund essential projects, without needing to worry about the possibility of inflation. Such spending always adds new financial assets to those held by the private sector as a whole, thereby boosting its ability to spend, save and invest, which in consequence exerts downward pressure on unemployment. Public borrowing is the conventional route, however direct funding from the central bank is entirely possible and the latter route has been employed in the past, especially during times of crisis.

There is no shortage of useful projects to which such funding can be directed. Topical and important examples include (a) the provision of government grants to research bodies concerned with developing alternative methods for electrical power generation to those which depend upon burning fossil fuels; (b) increased grants to citizens for the purpose of assisting them to install solar panels on their houses; (c) making education affordable at all levels to those who desire it and are qualified to undertake it, without obliging those at the start of their working life to service crippling education debt – in other words, recognising that education is an investment in the future of our country; and (d) grants to local governments for justified projects.

All of these things, and much more, are possible. What needs to change is the mindset of those who have not understood that the dysfunctionalities in the prevailing economic system can be successfully tackled and eliminated. The first line of attack must include educating the average citizen and the journalists who write for them, who continue to misunderstand the nature of the forces which are moulding and controlling their lives, and also the groupthink of those in positions of power and influence in our society who – in many cases – have been led unwittingly to believe that there is no alternative.

* Quote from the late Prof John Hotson (cofounder of COMER, the sister Canadian organisation to ERA)

John Hermann

Federal government spending is different from household spending

It is not unusual to hear from politicians that government spending and household spending operate according to the same overall principles. This narrative usually states that households and governments must both “live within their means”.

And although many astute commentators recognise that attempts to draw an analogy between government and household financing are fallacious, they fail to recognise that the reason for this fallacy runs much deeper than their commonly expressed observation that government expenditure leads to some return in the form of revenue for the government.
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For several decades now, currency-issuing countries around the world have been operating without a gold standard to back their respective currencies. Modern currencies are based on pure state fiat money, backed only by the ability and willingness of each central government to tax its citizens.

Unfortunately mainstream economists have largely not yet caught up with the implications of this relatively new situation, and consequently they do not understand the significance of the development of modern monetary theory (MMT) and what it is all about.

Amongst other things, MMT proposes that monetarily sovereign governments (this includes our federal government but not our state or municipal governments) do not need to rely on taxation revenue in order to effectively spend into the economy without having to worry about inflationary pressures or potential rises in interest rates.
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Deficit spending, whether accommodated by issuing Treasury bonds to the private sector or more directly to the central bank, allows the central government to inject new net financial assets into the private sector, as deemed appropriate for the purpose of enhancing aggregate demand, boosting the ability of the private sector to save and invest, and reducing the overall level of unemployment. Only central government has the ability to create net financial assets in this way; it never needs to “balance” its budget, and can never go broke.
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Putting it another way, a central government which is monetarily sovereign will always live within its means, because it has a bottomless pit of financial assets (denominated in dollars, and easily convertible into actual dollars if this is required) at its disposal. There is no risk of inflationary pressure from deficit spending in circumstances where the economy is operating below its capacity to produce goods and services (such as right now!). None of this applies to a household, or to household budgeting.

John Hermann