More on Budget Deficits

The previous post, which emphasized a currency-issuing government’s capacity to deficit spend, generated lots of positive feedback but also numerous questions that perhaps should be addressed in a new post rather than getting buried in the comments. Although for regular readers the general answers to these questions will already be evident from previous posts and comments, it may be helpful for newer readers to expand on these answers. In doing so, I’ll end up touching on a few points that have not been discussed explicitly in previous posts (though sometimes in the comments), which may make it of interest to regular readers as well. The post is a modified version of one of my contributions to the comments.

The following questions are addressed:

1. If the government is not like a household, how come Greece, Spain and Detroit have got themselves into financial trouble?

2. In what sense does government spending create money and taxes destroy it?

3. How can money created out of thin air have any value?

There were a couple of other interesting issues raised in the comments, but I will leave discussion of those to future posts.

Answer to Question 1: The Governments of Greece, Spain and Detroit are Not Sovereign in Their Own Currencies

It was stated in the previous post that the “US government, and most other national governments, can never run out of money because they are the original sources of the money they spend. They issue their own currencies. Exceptions are state governments and member nations of the European Monetary Union, who are mere users of currencies, not issuers of them”. In other words, a government is only free of a revenue constraint if it issues its own currency.

The national governments of Greece and Spain do not fall into this category. Nor does the state government of Detroit. These governments are users of currency, not currency issuers. In the case of member nations of the European Monetary Union, such as Greece and Spain, governments gave up their sovereignty by agreeing to use the euro, a common currency issued by the European Central Bank. As a consequence, these governments need to obtain the currency before they can spend. They are revenue constrained. State governments in federal systems and local governments are also mere currency users, and so revenue constrained.

Revenue-constrained governments can always be bailed out by the currency issuer, but not by their own power, and not necessarily in a manner to the liking of their constituents. For example, the European Central Bank requires savage austerity measures in Greece as a condition of funding.

European national governments who have committed to using the euro have therefore willingly handed over monetary control to a body that is not democratically accountable to the respective national populations. The class-interested motive for this is transparent. The arrangement clears the way for an attempt by the 1 percent to undermine organized labor and real wages, dismantle the welfare state, and inhibit other social-democratic policies favored by national populations. These draconian measures can be demanded by the European Central Bank in return for any financial rescue package it extends.

The situation is qualitatively different in the case of state governments in federal systems as well as for local governments in that citizens of those states and localities still have some democratic influence over the election of the federal government, which does have the authority to make fiscal transfers. In reality, though, federal systems have also provided quite an effective weapon for the 1 percent, even if not to the same degree as the European common currency. When it comes to making fiscal transfers to the states, the federal government is in a position to dictate terms in much the same way as the European Central Bank dictates terms in Europe. If, as has obviously been the case in recent decades, the federal government serves the interests of the 1 percent to the detriment of the general community, it can make transfers conditional on socially destructive policies, such as slashing spending on education or public services. I have discussed this in more depth in a previous post.

Answer to Question 2: A Currency Issuer’s Capacity to Spend Is Neither Enhanced Nor Inhibited By Previous Tax Receipts

The spending of a currency-issuing government creates financial assets out of nothing (ex nihilo) and taxes destroy financial assets. Once taxed away, the financial assets don’t come back. They’re gone. But the government can always create more through spending.

More specifically, government spending creates a particular type of government money called reserves. These are held by banks in special accounts with the central bank (or central banking system). For instance, when the government pays Joe Public $100, the reserve account of Joe’s bank is credited for that amount and the bank is directed to credit Joe’s account for the same amount. The $100 deposit in Joe’s account is a financial asset for Joe and a liability for the private bank. However, the private bank’s liability is matched by an asset, the new $100 in its reserve account. The net effect is to increase the non-government’s financial assets by $100, the amount of the government spending.

If the government spending is not matched by taxes, then under normal circumstances the central bank will then exchange the reserves for government securities. Since both reserves and government securities are financial assets of the non-government, this does not change anything important to the present discussion. It remains true to say that government spending creates net financial assets.

Conversely, if Joe pays $100 in taxes, this amount is debited from his private bank account and debited from the private bank’s reserve account at the central bank. This causes Joe’s financial assets to decrease by $100 (his deposit has been reduced by this amount). The private bank has a smaller liability to Joe (by $100), but this is matched by the reduction in the bank’s reserves (its asset) at the central bank. The net effect is that the non-government has $100 less in financial assets than before the taxation.

The government will certainly keep appropriate records of past spending and taxing, but money paid in taxes is not re-spent back into the economy. It is gone/destroyed. This has no impact on the government’s capacity to spend in the future.

Answer to Question 3: Government Money is Tax Driven

The viability of a currency depends on people desiring to obtain it. For government money, this desire is created through the imposition and successful enforcement of an obligation on some or all citizens that is denominated in the government’s own unit of account. In modern times, taxes play the primary role, but fines, fees and other obligations play an equivalent function. By requiring the payment of taxes or some other payment in the government’s own unit of account, the government creates a need within the non-government to obtain the government’s money.

If the government spends too much relative to the level of taxation, there will be demand-side inflationary pressures. An appropriate deficit will be one that enables sufficient demand to sustain full-employment output at current prices. Since, normally, the non-government attempts to run a surplus (spend less than it earns), this will, by definition, require a budget deficit. The greater the desired non-government surplus, the greater the budget deficit can be without creating inflationary pressures.

None of this is to suggest that any kind of non-government surplus is desirable and should be accommodated by deficit spending. A large intended non-government surplus might partly reflect extreme income and wealth inequalities, in which case policies will be needed to redress them. Redistributing income and wealth downwards through progressive taxes and transfers would enable stronger consumption demand for any given budget deficit, because low-income households spend a higher proportion of their income than high-income households and the wealthy. In all likelihood it would also result in stronger overall demand and employment for any given budget deficit.

A budget-neutral introduction of some kind of income guarantee, in which the wealthy were taxed more than they received in income and low-income households paid less tax than they received would probably bring about a considerable improvement in overall demand and employment. Even so, a budget deficit would still be appropriate to the extent that the non-government in aggregate intended to be in surplus, and this is the normal intention due to the uncertainties built into the current economic system.

A policy approach favored by modern monetary theorists, which follows logically from the above considerations, is to introduce a job guarantee. This would involve government making a standing offer of a job to anyone willing to accept it. The job-guarantee wage would define the minimum wage and benefits package and the job-guarantee provider would not permit itself (be permitted, if the provider were private) to compete on wages with employers in the broader economy. The policy would ensure full employment irrespective of the size of the budget deficit. It would then become unnecessary to accommodate the non-government’s desired surplus whenever such a surplus was considered socially and economically counterproductive or damaging. Since the job-guarantee provider would not compete on wages, the policy in itself would not be inflationary. If economic activity picked up in the broader economy, employers would entice workers out of the job-guarantee program because of the higher wages and better conditions. Any inflationary pressures that emerged in the broader economy due to strong private credit creation would be kept in check through appropriate fiscal measures as well as tight banking and financial regulation.

Some combination of the two basic approaches – progressive tax/transfer policies and job guarantee – could be implemented, simultaneously reducing the non-government’s desired surplus and establishing full employment alongside price stability. My personal preference is for a combined ‘job or income guarantee‘.

5 thoughts on “More on Budget Deficits

  1. If, in a perfect world, where sovereign (in currency) governments play their part in bringing about full employment and rising standards of living for all, i’m intrigued as to whether commenters think that wealth inequality (financial and real assets) needs to be tackled or not.

    i presume concentration of wealth has implications for bubbles but I don’t seem to come across much discussion of the need to tackle it in the blogosphere.

    Or maybe we don’t

  2. The spending-creates money is simple: currency is a government liability. When the government spends, it creates a new liability. When it taxes it extinguishes a liability. When it borrows it issues a new liability in the form of a bond and extinguishes a previous liability in the form of currency.

  3. Respectfully y – I just wish economists had their heads screwed on the other way, and were looking in the other direction!

    ‘Currency is a govt. credit. When govt. spends it spends some of its theoretically ~infinite amount of credit (human values and capabilities, and real resources in the skin of the earth, are the constraint).

    When it taxes it withdraws credit. When it borrows it withdraws credit with the promise to pay it back plus a little more’.

    Kids in a playground issue credit all the time. Then they say ‘ you owe me …’! Biggest issue in the playground is bullying.

    It is so frustrating because it is so simple. Its like species myopia … can’t see the credit for the liabilities.

    Makes me shiver …!

  4. Ok, since we are all offering up our own interpretation of monetary ops, here’s mine:

    Melodramatic Movie: The Rent.

    Villain (Market Bond Vigilantes): You must pay the rent!
    Damsel (Treasury): I can’t pay the rent!
    Villain (Market Bond Vigilantes): You MUST pay the rent!
    Damsel (Treasury): I CAN’T pay the rent!
    ::Menacing Music::
    Concerned Narrator (Economists): WHO will pay the rent?
    Hero (Fed): I’LL pay the rent!
    Damsel (Treasury): My HERO!
    Villain (Market Bond Vigilantes): Shucks, foiled AGAIN!

    The End.

    Academy Award for Best Original Screenplay, 100 consecutive years running with no competition in sight.

  5. Andy: I would also be interested in reading other views on the topic.

    My take in brief:

    In moral philosophical terms, it is difficult to justify much inequality at all other than that tied to capabilities (a la Sen). For instance, a sick person needs more resources than a healthy person, other factors remaining equal. Other than that, I’m not sure what makes a person imagine it’s okay to have more than others. They must think they’re really special. I mean, they are, but so are the rest of us. 🙂

    Extreme inequality means that a tiny cohort of the population has:

    — an overwhelming command over society’s real assets;

    — excessive influence over the political and electoral process, both directly and indirectly through media ownership and control;

    — not just market power in narrow pricing terms but clout sufficient to shape (subvert) the entire direction and nature of socioeconomic development, including the regulatory and legal framework, industrial relations and the conditions of employment, the content and delivery of education, and so on.

    I think you are right to link bubbles with extreme inequality. Historically, inequality reached extreme levels immediately prior to both the Great Depression and the current Great Recession. In the three decades of stagnant income and real-wages growth preceding the present crisis, consumption demand was maintained through increasingly unregulated private credit creation, a process that has clearly proved unsustainable.

    Trixie: Great find. Some academy award performances there for sure, and so cute in execution. I’ll look out for the Inside the Actors Studio appearance with James Lipton.

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