We Just Voted to Live Beyond Our Means (Though Maybe Not In the Way We Think)

It is quite common to hear that “we should not live beyond our means”. Well, in Australia, we have just voted to do so. Our most recent vote says, “we need to live beyond our means so that the government sector can move into surplus”. The LNP promises to balance the budget or put it into surplus by 2020. This means a vote for the LNP was a vote to be living beyond our means by 2020. Likewise, the ALP promised to balance the budget or put it into surplus by 2020. A vote for the ALP was equally a vote to be living beyond our means by 2020. The Greens adhere in their constitution to a principle of balancing the budget on average over the business cycle. A vote for the Greens was therefore a vote to live beyond our means on average. Taken together, these three parties attracted about 87 percent of first-preference votes. So, at the very least, 87 percent of us have voted for the country to live beyond its means, no later than 2020.


A Government Surplus Would Mean That We Are In Deficit

Here is a simple accounting relationship:

Private Sector DEFICIT = Government SURPLUS + Foreign SURPLUS

This identity (true by definition) divides the economy into three sectors. A sector is in deficit when its total spending exceeds its income, and in surplus when its total spending is less than its income.

The private sector is us. It comprises all private businesses and households, including the households of public servants and politicians. The government sector is an entity that acts on our behalf, creating and enforcing laws and regulations, spending and taxing, and also employing a portion of the workforce. Its employees work in the public sector, but live in private households. Their income forms part of private household income, and their expenditure forms part of private expenditure. The foreign sector is everybody else in the world, including overseas households, businesses and governments.

A government surplus occurs when the government spends less than it charges in taxes. A foreign surplus occurs when foreigners receive more income from us – through sale of goods and services and receipt of interest and dividends – than we receive from them.

The identity shows that when the government and foreign sectors both maintain a surplus, the private sector must be in deficit, spending more than its income. Of course, some of us in the private sector will be spending less than our income. But, as a sector, overall private spending will exceed private income.

We could express the above identity in reverse. That is, if we in the private sector maintain a surplus by spending less than our income, one or both of the government and foreign sectors would have to be in deficit.

Historically, Australia has run a current account deficit, so foreigners are normally in surplus. If this trend continues, and it almost certainly will, it is impossible for the government to run a surplus unless we in the private sector are reckless enough to spend more than our income. If, instead, we behave sensibly and seek to maintain a private sector surplus as protection against future unpredictable economic events, the government will be in deficit. This will be so whether it wants to be or not, and whether we want it to be or not. It is a simple matter of accounting.

However, there is no need to panic about this. There is nothing inherently problematic about government deficits. There is nobody relying on tax revenue for their income and no one personally out of pocket due to government spending. That is not how things work.

In a nutshell, things work like this:

Government spending creates (i.e. issues) the currency. This act of spending injects the currency into the economy. We (the private sector) receive this spending as income and have more in our pockets or bank balances as a result.

Taxation has the reverse effect. It takes currency out of the economy. As a consequence, we (the private sector) have less in our pockets or bank balances.

By demanding that the government get into surplus, we are actually demanding that we in the private sector spend more than our income. We can only do this by:

  1. running down our past savings
  2. borrowing from banks or other financial institutions
  3. receiving more income from the rest of the world than we pay to it.

Since, like many countries, Australia normally runs a current account deficit, option 3 is infeasible. We actually receive less income from overseas than we pay to foreigners. This translates into a surplus (in Australian dollars) for foreigners. There is nothing inherently bad about this. But we need to keep in mind its implications when considering whether it is sensible for government to attempt to maintain a surplus.

Many of us have been misled into believing that government deficits imply “living beyond our means”. Hopefully it is clear from the above that the opposite is closer to the truth.

 

The Australian Government Cannot “Run Out of Money”

We have often been told that government debt is the problem when in truth it is private debt that is potentially of concern.

Consider the following questions.

  • As members of the private sector, is it possible for us to get into debt problems?
  • Can private businesses go bankrupt?
  • Can individuals lose their jobs and find it impossible to repay a housing or car loan?

The answer to all these questions is clearly yes. It seems almost too obvious to mention. Private debt can be a serious issue. Households are financially constrained.

What about government?

  • Can the Australian Government go broke?
  • Can it ever be impossible for the Australian Government to meet an obligation denominated in Australian dollars?

The answer to each of these questions is no. The government is the creator of the currency in which it spends. A currency issuer is not like a household. It faces no revenue constraint.

Despite this, we have voted for the government (at least by 2020) to spend less dollars into the economy than it takes out in tax receipts, perhaps on a misunderstanding that this would somehow safeguard the government’s solvency.

In seeking to ensure that government never runs out of a currency that it alone creates (a logical impossibility), we have in effect voted for the private sector (again, that’s us) to spend more than our income. We have voted to push actual real-life people into debts that they may ultimately find difficult or impossible to repay, or to run down private savings, so that the government entity – whose income (tax revenue) is basically an accounting construct and goes into nobody’s pocket – can spend less than it taxes. And we have thought that this would help us to live “within” our means.

 

Did Somebody Murmur Something About Inflation?

Perhaps some of us believed also that government spending needs to be reined in to avoid runaway inflation.

Perhaps we read this in the Herald Sun or the Daily Telegraph or one of Rupert Murdoch’s other newspapers when they were not opining about the government supposedly being out of money? Or a Fairfax newspaper? Or perhaps we saw it on the ABC or SBS? Or one of the commercial channels? Or Pay TV? Or heard it on the radio? Or came across it on the internet? The false message is all around us. No wonder there is confusion.

The truth is government spending has the same effect on prices as any other kind of spending. If the level of total spending in the economy as a whole is too low to maintain healthy levels of economic activity, an increase in spending (whether public, private or foreign) will mainly induce a quantity response (businesses selling more output to customers) rather than cause an excessive escalation of prices.

Suppose one of us is a private tutor, or runs a hairdressing salon, or manages a supermarket, or perhaps owns one of those newspapers mentioned above.

Let’s say a customer walks in off the street with $50 and asks for tutoring / a haircut / groceries / a selection of newspapers.

What should we expect to happen?

More likely than not, the customer will get some tutoring / a haircut / a cart of goods / a selection of newspapers at going prices. The quantity of output sold to customers will increase as a result. The effect on prices, in all likelihood, will be small to zero.

Exceptions will occur if and when a supplier of some good or service is at the limit of what can be physically produced within the relevant period. Otherwise, with spare capacity and underemployed labor (including hired staff operating at less than peak intensity), output will rise with little to no effect on prices.

In other words, the constraint on government spending should be defined in terms of real resources, not money. If there are goods and services available for sale in Australian dollars, the government can always afford to purchase them. The required dollars are created in the act of government spending.

Notice, in our illustration, that it does not matter whether the customer with the $50 is an employee of a private corporation, a public servant, a small business owner, Rupert Murdoch, a pensioner, a benefit recipient or someone else. To the private tutor / hair salon operator / supermarket manager / newspaper proprietor, fifty bucks is fifty bucks. Its effect, when spent, is the same no matter who spends it.

Now, if excessive inflation is on the radar, any extra spending will be problematic, whether public, private or foreign. In those circumstances, it will make sense for government either to cut spending or raise taxes. But more often than not – and certainly at the moment and for the foreseeable future – the level of spending is too weak, not too strong.

 

For Taxes To Be Paid, the Currency Has To Exist

One big reason there is such confusion surrounding government deficits and public debt is that we are mostly taught to look at things the wrong way round. We are told that the government needs our tax payments in order to spend. Similarly, we are told that the government needs to borrow from us in order to spend more than it taxes.

Both these misconceptions result from looking at things upside down.

Australian taxes are owed in the government’s own money, or ‘government money’. By ‘government money’ is meant either hard ‘currency’ (notes and coins) or special balances that commercial banks hold with the central bank called ‘reserves’. Reserves are used for the final settlement of transactions, including transactions between government and commercial banks acting as our agents (such as when we pay taxes).

Until the private sector possesses either currency or reserves, we can’t pay our taxes. And we can’t create these ourselves. Nor can the commercial banks. Commercial banks can create deposits denominated in Australian dollars but not actual currency and reserves. These only originate from the Australian Government. If we did try to create our own currency, it would be counterfeiting, and we could go to jail for that.

The only sector permitted to create currency and reserves is the government sector. This means that, from inception, the government must create dollars before we can pay our taxes:

Government spending logically comes before tax payments and is what makes paying taxes possible.

Government spending injects dollars into the hands (or bank accounts) of private households and businesses as income. This income can then be used to spend, save or pay taxes. If spent, the dollars go as income to somebody else who, in turn, can spend, save or pay taxes.

Ultimately, all dollars spent into the economy by government end up either taxed away or held in the form of savings.

Put simply, government spending enables the payment of taxes and private saving. It is not the other way round. Government does not need our taxes in order to spend. To the contrary, we need the government to spend in order for us to pay taxes and save.

Moreover, if the government runs a deficit more than sufficient to offset the current account deficit, we (the private sector) are able to maintain a surplus in which we spend less than our income. Since we, and not the government, are at risk of insolvency, it normally makes sense for government to do this. Private sector surpluses help to cushion us against unpredictable events, such as losing our jobs or businesses.

It is much the same story with so-called government borrowing. From inception, it would be impossible for the government to “borrow” currency or reserves from the private sector (us) before it had created them. Government borrowing is simply an operation in which the private sector is able to hold some of its net financial wealth in the form of government bonds rather than currency or reserve balances.

Here, too:

Government spending is logically what makes the purchase of public debt possible.

The issuance of public debt poses no solvency issue for the Australian Government. Nor does the interest owed on public debt. Relevant questions for policymakers concern the demand and distributional effects of public debt and interest payments. It is never a question of “affordability”.

In this respect, it is important to understand that the average interest rate paid on government debt is entirely at the discretion of government. When it decides to pay a positive interest rate, this is a decision to inject additional income (in the form of interest) into the private and foreign sectors. The government, as currency issuer, can obviously always make these interest payments, though it will want this flow of payments, like all other government spending, to be sensible in relation to total spending (since some of the interest income will be spent on real goods and services) and in accord with the electorate’s priorities regarding income and wealth distribution.

Government deficits add net financial assets (currency in circulation + reserve balances + government bonds) that can then be held in the private and foreign sectors. In fact, it is an identity, true by definition, that the size of the government deficit equals the amount of net financial assets added to the system over the period.

Following the same logic, the total accumulated ‘government debt’ equals, by definition, the accumulated Australian-dollar-denominated net financial wealth. A call to “pay off the government debt” is therefore a call to “eliminate all net financial wealth denominated in Australian dollars”.

That would be a counterproductive move, to say the least.

 
Further Reading

An academic treatment of the topic for scholarly readers:

Stephanie Kelton: Can Taxes and Bonds Finance Government Spending?

Related posts for general readers:

Budget Deficits and Net Private Saving
Government Spending or Lending Logically Precedes Tax Revenue
MMT in Simple Parables
What Everyone Should Know About Budget Deficits and Public Debt
Exercising Currency Sovereignty Under Self-Imposed Constraints

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