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Our false view of deficits and money

January 21, 2011

In political debates throughout the developed world, the most prominent divide today is almost certainly that between the needs of society for unemployment safety nets, retirement and pension programs, health care spending, and desired public services versus the demands of the bond market to slash spending in order to reduce budget deficits.  The issue is sometimes presented in terms of morality as in “it’s wrong to spend what you don’t have” or “it’s only right that governments, like individuals, manage their finances soundly”.  It’s also sometimes presented in a particularly grating parental tone as politicians site a need to have an “adult conversation” with their presumably childlike constituents.

There are two things about this debate that literally scream out for attention.  The first is that it’s a completely contrived and false issue having absolutely no bearing on the true nature of money and debt.  Individuals can be in debt to others but it’s utter nonsense to think of societies as somehow capable of being in debt to themselves.  Societies are not individuals.  The second thing is that a very tiny number of elites along with their political and intellectual supporters derive enormous benefits and power from the view that deficits are important.  They’re the monied titans that comprise what we call the “bond market” and we’re repeatedly reminded we must change our ways and appease this apparent force of nature.  Obama’s former Director of the Office of Management and Budget Peter Orszag, now lucratively sitting as vice-chairman of global banking at Citigroup, instructs us in today’s Financial Times: “it is … difficult to see the political system embracing that reality (of deficit reduction) without being forced to do so by the bond market”.  Another article right along side it, entitled “Only tough reforms can save the land of the rising debt”, warns us “… if Japan does not switch course voluntarily (reduce deficits), it may soon find that financial markets will force changes upon it.”  We’ve virtually ceded democracy to those with extreme wealth who, motivated only by private greed, claim a right to decide the limits of possible prosperity within societies.  Politicians from “center-left” through the right support them and in turn are supported by them.

In this post, I seek to make the argument that there’s no sound justification for this transfer of power and there’s every reason to reject the entire discourse and move to a democratically based monetary regime which permits maximum prosperity for all.  It’s not too great an overstatement that the key to overcoming most of our problems is a changed monetary system.  For is it not clear the technology exists today for widespread prosperity and the only thing holding it back is a lack of purchasing power (i.e. money)?    Monetary policy is not mainly an economic issue, it’s political in the deepest sense of the word.  It cannot be left in the hands of economists or those in high finance.

Let’s jump to the central point: we have what is known as a fiat currency.  It’s not backed by gold or any other commodity and we, i.e. the government, can issue it without cost by simply crediting a bank account.  This immediately should seem strange – is it not the height of lunacy for a government to feel the need to borrow something which it can in fact produce at will?  Or to adjust its policies to induce others to lend it back its own fiat currency?  The whole thing appears absurd.   Is it not equally ludicrous to think we, i.e. the government, must rely on tax receipts in order to obtain this currency?  We should pause for a moment and ponder this.  If we can create our currency without cost, then clearly we don’t need to rely on taxes or borrowings to generate it.  This is counter to all normally accepted intuitions but with only a little thought it must be admitted this is unarguably true.

This being the case, what is the purpose of borrowing and taxes?  The reality is they are not means of generating funds for government spending but are, rather, only monetary tools that serve no purpose other than reducing the money supply.  Both taxes and borrowing do the same essential thing – they drain money from the economy.  The Federal Reserve, in fact, routinely manages interest rates with this understanding of money and adjusts its borrowing levels on a daily basis to meet its monetary targets.

Those who claim government spending should be limited to the sum of tax receipts and a low level of borrowing are in fact favoring a policy of austerity that limits societal spending regardless of need.  They base their views on an unfounded conception that any monetary spending must be offset by either of the two monetary tools of contraction, i.e. taxes or borrowing.   Why should that be?  If the economy is suffering from unemployment and underutilized resources, what possible reason exists to think monetary creation needs to be offset by monetary contraction?  Yet that is precisely the standard orthodox view of finance.  Monetary creation beyond the limits of the economy is certainly unwise and would be inflationary.  But why would monetary creation limited to the productive capacity of the economy be so?  All past periods of prosperity involved the “printing of money” through private bank credit.  The boom in the late 90’s and the recent mortgage boom involved massive private money creation through debt and yet there was virtually no inflation.  Why should economists condemn the government printing of money yet not object to the private?  Can anyone seriously believe that expanding purchasing power in today’s environment could possibly be inflationary?

To sum up my argument.  The government should create sufficient purchasing power directly through monetary creation in order to provide full employment and utilization of resources.  It should only use borrowing and taxes to reduce purchasing power when capacity is being reached and the economy is in need of contraction.  Borrowings over an extended term would likely be level as they would decline when the economy was doing poorly and would rise when contraction was needed.  Since borrowings are only monetary, interest rates on debt could be maintained at zero percent and so interest on debt would not be an issue.  Going further, one can see that borrowings are almost identical to reserves held by banks at the Fed.  The government could establish reserve requirements for those with great wealth that would fluctuate depending on monetary policy.  This is not the time to expand further on the many options for treating monetary contractionary tools.  The critical point is to recognize the monetary nature of it all and the truly democratic opportunities for prosperity that a change in view entails.

There’s a great deal of theoretical support for this line of thinking.  Abba Lerner was an early Keynesian economist who coined the term Functional Finance in the early 1940’s.  This key article clearly expresses the monetary nature of debt and the need then (as now) to drop the false notions of financial orthodoxy.  The guru of right wing monetarism, Milton Friedman, penned this article in 1948.  He recognized the same reality and I would think the article should make those who reject this argument take pause.  Friedman argues for eliminating the private banking power to create money and supports “as the chief function of the monetary authorities, the creation of money to meet government deficits or the retirement of money when the government has a surplus”.  He concludes that  “…government expenditures should be financed entirely by either tax revenues or the creation of money”.  By today’s standards his proposal is radical but its general thrust is not too different than what is argued here.  There are economists who are making the same points today, including Jamie Galbraith and L. Randall Wray (see here and here).  But these perceptive scholars are either ignored or even portrayed as near lunatic.  The false undemocratic consensus is that strong.

It’s well past time we on the left, those who passionately seek a better and more democratic world, recognize the monetary nature of much of our problems and demand our leaders stop creating artificial barriers to our prosperity.

(I’ve written other posts on this issue which are filed under the Monetary/Fiscal tab.)

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  1. Tom Hickey permalink

    Good observation, with one quibble:

    “Both taxes and borrowing do the same essential thing – they drain money from the economy. ”

    Not exactly if this is taken to mean that they do this in the same way.

    Government expenditure increases (injects) nongovernment financial assets, and taxation decreases (withdraws) nongovernment NFA. Budgetary deficits increase nongovernment NFA, budgetary surpluses decrease nongovernment NFA.

    Tsy issuance drains excess reserves resulting from deficits by chaning asset composition from bank reserves to tsys. There is no change in nongovernment NFA, although the interest paid on tsys does increase nongovernment NFA since it adds to budgetary expenditure. The issuance of tsys simply changes asset composition and term structure without injecting or withdrawing financial assets from nongovernment.

    Bank reserve are similar to an ordinary deposit account, except reserves are held by banks in their accounts at the Fed, and tsys are similar to a CD. Switching funds back and forth between one’s deposit account and CDs only changes the interest one receives, not the amount involved. Same with reserves and tsys. However, there is no time constraint or interest penalty in the case of buying and selling tsys, as there is with CDs.

    In summary, government expenditure and taxation are fiscal operations that affect nongovernment NFA, and tsy issuance is a monetary operation that does not affect nongovernment NFA other than through interest paid out.

  2. Perhaps we can become confused with the difference between fiscal and monetary. In a fiat currency regime, my point is that everything is monetary. The government can spend without constraint since it has control of the press. Taxation therefore serves only one purpose, that being to reduce the money supply. Calling them fiscal operations, I think, distorts the picture since it implies some connection between expenditure and taxes when there’s no reason to suppose one.

    Naturally I agree that treasury issuances are monetary transactions as that is an essential part of my argument. They don’t effect non-government net financial assets but I don’t see that as being important to the argument. Borrowings remain monetary tools that drain the level of purchasing power from the economy.



    • Tom Hickey permalink

      The point is that taxation actually withdraws nongovernment NFA. Tsy issuance iaw the $-4-$ deficit offset forces saving, which simply makes the nongovernment NFA slightly less liquid in exchange for interest paid for this sacrifice of liquidity. Thus, thus they function quite differently, and this should be noticed.

      In a fiat regime, in which the government is monetarily sovereign (in the US the federal government but not the state governments), the government is not operationally (financially) constrained because it is the currency issuer and there is no limitation on currency issuance. Therefore, the government does not need to tax to fund itself and it does not need to borrow to finance itself.

      On one hand, taxation withdraws nongovernment NFA, which reduces nominal aggregate demand, according to Lerner’s functional finance, thereby reducing inflationary pressure should NAD approach the capacity of the economy to produce.

      On the other hand, tsy issuance (“borrowing”) is operationally unnecessary in a fiat regime, and it can be eliminated. In the US it is required because of voluntary restraints imposed politically in the name of fiscal discipline. Since tsy issuance is unnecessary, interest paid on tsys constitutes a subsidy to tsy holders. This is a special interest subsidy unless it can be justified in terms of public purpose.

      So there are an important differences to note between taxation and tsy issuance.

  3. I can generally agree with your points. Borrowing is certainly not exactly the same since taxation completely eliminates potential demand whereas borrowing places it into something like a safe. The term “borrowing” though is completely misleading in a fiat regime since, as you note, there’s no reason for it. Some neutral term like “monetary reserve” is far more appropriate. I avoided going into too much detail as I wanted to keep the post as short as possible.

    There are all types of ways that could be designed to contract purchasing power should we ever get to the stage of a progressive monetary policy. I personally believe we should tax any large amount of wealth at near 100% and that would tend to eliminate this particular issue along with the undue influence of power. An alternative if we didn’t want to go that far could be requiring wealth over a certain level to maintain deposits in reserve. There are many ways this could be handled but the essential point is that the phobia of deficits is completely misplaced. I tend to think we see eye to eye on that.

    Your point that interest is a subsidy to bond holders is well taken. It’s very difficult for me to see a valid purpose for society paying a return on a riskless asset. If a valid reason could be concocted, then I’d argue it should be taxed away so that there would be no net transfer to wealth.


  4. Tom Hickey permalink


    The notions of taxing to fund and borrowing to finance have no place in the universe of discourse relative to a fiat system since they are operationally precluded, although political restraints may be imposed to mimic this feature of convertible fixed rate systems like the gold standard, as well as to create the illusion that government finance is the same a household and firm finance even though the former is the currency issuer and the latter are currency users.

    According to functional finance, to regulate aggregate demand relative to potential supply and employment, government should use expenditure to inject financial assets and taxes to withdraw financial assets. Unlike monetary policy using interest rates and Taylor rules, which are blunt instruments, both expenditure and taxation can be tightly targeted for effect.

    The way that taxation is best targeted in the context of a modern economy is toward taxing away economic rent, which is unproductive. Economic rent includes land rent, monopoly rent, and financial rent. Taxing away economic rent as appropriate iaw functional finance 1) discourages rent-seeking, which is parasitical on the economy and constitutes a leakage, and 2) incentivizes productive investment/production and cultivates income/consumption. balancing supply and demand at full employment. In addition, taxation can be directed at decreasing negative externalities.

  5. Calgacus permalink

    The point of bond issuance according to Lerner – see his Economics of Employment for instance, is to raise interest rates. This can curtail marginal, hare-brained-scheme types of speculation, and also during times of full employment, as with war bond sales during WWII, can reduce or postpone demand, to reduce inflation. (I’d say more but have misplaced my copy for the moment.) Jim, saw your wandering in hostile territory – . There have been decent arguments there.

    Why should economists condemn the government printing of money yet not object to the private?

    As most are mouthpieces of banksters – their problem is “where’s the boss’s vig then?”

  6. I think the purpose of borrowings is a little nebulous, unlike taxing which clearly destroys purchasing power. Borrowing raises interest rates by taking money out of private circulation. The two sort of go hand in hand. But I think the government also borrows for another reason – a simple carry forward from the commodity view of money which of course benefits wealthy interests. As Tom Hickey points out, “political restraints may be imposed to mimic this feature of convertible fixed rate systems like the gold standard, as well as to create the illusion that government finance is the same a household and firm finance even though the former is the currency issuer and the latter are currency users.”

    I’m suspicious of the stated reasons for raising interest rates. It fits too perfectly into the “interests” of wealth to maintain high returns on capital. JK Galbraith pointed out many years ago how inefficient interest rate policy was in slowing an economy.

    I think a very strong case can be made that the Fed should always maintain the short term interest rate at zero. And going further, it should only issue debt for short term maturities at the zero rate. Those with wealth are appalled at the idea of workers getting a “return” for not working; why should capitalists get a return on a riskless asset? A great subject for a future post!


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