What Everyone Should Know About Budget Deficits and Public Debt

We are subjected constantly to threatening talk by politicians and media personalities about budget deficits and public debt. Budget surpluses, or at least balanced budgets, are touted as fiscally responsible, whereas deficits are painted as burdensome and unsustainable. This framing of the debate appears to be bearing fruit for the 1 percent it is intended to serve. For instance, a recent American survey reveals that almost half those polled opposed an increase in the debt ceiling to facilitate deficit spending while a further third of respondents indicated uncertainty on the issue. This is despite concern among respondents over what a refusal to raise the debt ceiling would mean for the economy. This suggests that people do not necessarily oppose the deficit spending other than for the supposed “affordability” issues they think it poses. In reality, there is no affordability issue and nothing inherently responsible in balancing the budget. To the contrary, such a move would be burdensome in the extreme, as well as unsustainable. Particularly at a time of high joblessness and underemployment, efforts to reduce rather than increase the deficit are the height of irresponsibility.

In most nations, including the US, the government can never run out of money. In the present discussion, ‘government’ shall be taken to mean the consolidated government sector, which includes the fiscal and monetary authorities. In the US, for instance, the federal government includes Congress, which authorizes taxing and spending measures, and the Federal Reserve, which serves as the monetary agent of Congress. 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 governments of the European Monetary Union, who are mere users of currencies, not issuers of them.

The fact that a government can never run out of its own money does not mean that any level of government spending is unproblematic, or that all government spending is good. But it does mean that deficits and surpluses need to be thought about in a different way than politicians and journalists would have us believe.

National governments such as the US federal government are sovereign in their own currencies because of the following factors:

1. The government is the sole creator and destroyer of its own money. It creates money when it spends and destroys money when it taxes.

2. The exchange rate of the currency is allowed to float on international currency markets. As a consequence, fiscal and monetary policy are not constrained by a requirement to maintain a fixed exchange rate.

3. The government does not borrow significant amounts in foreign currencies. It does not need any other entity’s currency in order to spend, and so has no need to borrow in other currencies.

Reflecting on these three factors for a moment turns the normal way fiscal issues are presented to us on its head. According to most politicians and media, the government needs to tax or borrow before it can spend. Taxing and borrowing, it is claimed, are funding measures. This framing of the policy debate plays right into the hands of the 1 percent, because it makes it seem as if popular policies such as social security, public education, public health care and public infrastructure might be unaffordable due to a lack of money, when in reality only a lack of real resources could ever truly make these policies unaffordable.

For a currency sovereign such as the US government, the truth is the opposite of the story normally presented to us. Until the government’s money has been created, no taxes could be paid and no government money could be borrowed.

The consolidated government sector creates money when it spends or lends. Once government money has been created, it becomes possible for the government to receive back tax payments or “borrow” back its money from the non-government sector.

Here, the non-government sector is defined to include both the domestic private sector (households and businesses) and the external sector (foreign individuals, businesses and governments). In short, we in the non-government cannot pay taxes or purchase government debt until we have obtained the government’s money, and this is impossible prior to its creation through government spending or lending.

So, as a matter of logic, government spending or lending is prior to taxation and public borrowing. Taxes and public borrowing do not — and could not — fund government spending or public lending. It is the other way round.

The government spends by crediting private bank accounts, or, equivalently, by paying checks to citizens that, once cleared, result in credits to private bank accounts. As a consequence, private banks will have more deposits and a corresponding amount of additional reserves. The latter are held in special accounts with the central bank. Since private bank deposits and reserves are financial assets of the non-government, government spending when considered in isolation causes an increase in non-government holdings of financial assets. Government spending creates financial assets.

Conversely, the government taxes by debiting private bank accounts. There is a corresponding reduction in private bank deposits and the reserves of private banks. Considered in isolation, taxation causes a decrease in non-government holdings of financial assets. Taxes destroy financial assets.

A budget deficit occurs when the government spends more than it taxes. The net result is an overall increase in financial assets held by the non-government. In other words, budget deficits increase net financial assets. Budget surpluses do the reverse, and balanced budgets keep the level of net financial assets constant.

Under current practice, the government matches any deficit with borrowing by issuing public debt. In effect, the extra bank reserves created by the deficit are exchanged for government securities. The net impact is that the non-government, taken as a whole, possesses more financial assets than it did before the deficit spending, but the extra financial assets are normally held in the form of securities rather than reserves. The qualifier “normally” is added because under some circumstances, including the present, some central banks are choosing to buy back previously issued government debt by crediting reserve accounts, thereby expanding the amount of reserves in the system (referred to as quantitative easing).

In aggregate, net financial assets comprise currency, reserves and government securities. The reason is that all other financial assets – private financial assets – are matched by private liabilities and so net to zero. For example, a private bank deposit is an asset of its owner but a liability of the bank, netting to zero for the non-government as a whole.

Operations such as public debt issuance and quantitative easing alter the composition of non-government net financial assets but leave the overall level of net financial assets unaffected. Debt issuance converts reserves held by the non-government into government securities. Quantitative easing does the reverse. Since both reserves and government securities are financial assets of the non-government, moving between them does not affect the non-government’s total holdings of net financial assets.

The current practice of matching deficit expenditure with public debt is unnecessary. Rather than issuing debt, the government could simply allow the extra financial assets to remain in the form of reserves rather than securities and pay the target rate of interest on reserves. This would make it more obvious to members of the general community that there is no funding difficulty for the government. No doubt this is the 1 percent’s real motive in continuing the charade of public debt issuance.

In any case, whether the government issues debt or not, the economic impact of the budget deficit will be the same. The non-government will have more financial wealth and so more capacity to spend. If greater spending occurs, there will be a boost to output and employment. Alternatively, the non-government might prefer to increase its rate of saving. Or, more likely, some combination of higher private spending and saving will occur. At a time when many households are overly indebted, increased private expenditure and increased saving to meet debt obligations are both desirable effects, and deficit spending makes both possible.

With all the above in mind, it becomes clear that government debt is not really “debt” in the way debt is usually conceived. If you or I (or a private household) are in debt, our means to pay it back are either (i) income we have earned or revenue we have received, (ii) past savings, or (iii) an additional loan to cover the earlier one. There is always a danger here of our debt becoming impossible to repay. If we lose our job, run out of savings or can’t obtain another loan, we may be forced to default.

The situation is very different in the case of a sovereign government. It can never become impossible for the government to make its debt repayments. The government does not need to obtain tax revenue in order to make payments. It does not need nor benefit from prior “savings” of tax revenues. The government can never have more nor less financial capacity to spend, irrespective of past spending and revenue flows. It simply repays debt plus interest as payments fall due through the issuance of government money.

In short, the government, unlike a private household, is not revenue constrained. For this reason, comparing governments to households on fiscal matters is incorrect as well as being counterproductive if it influences economic policy or our choices at the polling booth.

The important question when it comes to government policy does not concern money but whether the necessary real resources are available. A shortage of doctors and nurses would place a limit on the health care system. A shortage of teachers would do the same in the case of education. And so on.

All this raises a question. If taxes do not fund government spending, why are they necessary?

At the most fundamental level, it is the enforcement of tax payments that ensures a demand for the government’s money. By enforcing a tax obligation, the government ensures that we need to obtain its money, even if only to pay our taxes.

This gives the government the capacity to move some resources, including labor services, from the private to public sector. Some workers will be willing to work for the government in order to obtain money. For the same reason, some businesses will be willing to sell goods and services to the government.

Since we already have a need for the government’s money to make tax payments, there will also tend to be a general willingness to make private transactions in the same money or in other monies convertible at par into government money (e.g. private bank deposits) rather than look for some other, alternative money. In this way, people who do not transact directly with the government can obtain the government’s money indirectly through private exchange of goods and services with those who do.

Beyond meeting the tax obligation, it is not strictly necessary that we use the government’s money the rest of the time. As long as the government can move the desired resources to the public sector – as determined through the democratic process – the currency we use for other transactions among ourselves is not of absolute concern.

Nevertheless, for convenience and safety, we generally do transact in the government’s money or near equivalents such as private bank deposits. The government’s money remains trustworthy provided the tax obligation is effectively enforced.

In addition to making tax payments, many of us in the private domestic sector desire to save in the national currency. In aggregate, it is only possible for us to spend less than we earn – that is, to be in surplus – if at least one other sector runs a deficit. This follows from a basic accounting identity:

Private Sector Surplus + Government Surplus + Foreign Surplus = 0

A foreign surplus arises when foreigners accumulate financial assets in the domestic currency. This occurs when the domestic economy runs a current account deficit. In nations with current account deficits, the domestic private sector can only maintain a surplus if the government runs a deficit larger than the foreign surplus:

Private Sector Surplus = Government Deficit – Foreign Surplus

In general, budget deficits are appropriate whenever private domestic spending and export demand are insufficient to ensure full employment. The presence of unemployment indicates that we intend to save more and spend less than is consistent with full employment.

The consolidated government sector is in a unique position to alter the capacity of the private sector to spend while remaining in surplus. By increasing government spending, cutting taxes, or some combination, the government enables both extra spending and extra private saving.

If, instead, there happened to be full employment, and the government attempted to increase spending or cut taxes, the result would be an increase in prices with no real benefit in terms of output, employment or saving. In effect, the government would be attempting to purchase resources that were already being used by the private sector, and this would bid up prices.

In such a situation, a further transfer of resources from the private to public sector would be inflationary unless taxes were increased. Higher taxes would take away some of our spending power and leave more room for non-inflationary public expenditure.

In other words, the constraint on government deficit expenditure is inflation, which depends on the availability of real resources, not a lack of money. Inflation will occur if the government attempts to use real resources that are already employed in the private sector without increasing taxes.

In a situation like the present, though, with significant unemployment and many workers consigned to part-time jobs when they actually want full-time ones, there is plenty of scope to increase production without the expenditure being inflationary.

The main takeaways are these:

1. The government is not revenue constrained. Claims of the US government (and most other governments) running out of money or getting irretrievably into debt need to be recognized for the nonsense they are. There is no need for us to be tricked into voting for either higher taxes on workers or cuts in public services, education, health care, public transport, welfare, social infrastructure – the list could go on … – if we keep this simple fact about the monetary system in mind.

2. A budget deficit or surplus in itself is neither good nor bad. It can only be assessed in relation to the economic situation. Currently, unemployment and underemployment prevail. This indicates that in most nations the budget deficit is too small, not too large. This creates no real difficulty for the government but can give rise to a political obstacle if we are silly enough to fall for stunts such as the debt ceiling battle that, in reality, are played out precisely to deceive us into supporting austerity measures directly at odds with our own welfare.

 
Update 5 October 2013: Invaluable Article in the NYT

James Galbraith has written a much needed article for the NYT, published 2 October 2013, that covers the same ground as the present post. See this post for further discussion.

 
A Closely Related Presentation By Randall Wray

This video was posted to YouTube about a year ago now, so others will have linked to it previously. However, for those who have not seen it, it is well worth watching. It covers much the same material as the present post in an extremely clear and concise manner. It served as an introductory overview for the excellent “Modern Money and Public Purpose” series held at Columbia Law School. Videos of other presentations in the series are accessible on YouTube.

 
Related Posts

Fiat Money and its Social Significance

Budget Deficits and Net Private Saving

Critique of Reidl on Government Spending

How Much Fiscal Stimulus Will It Take?

Parable of a Monetary Economy

The Government is not a Household

Austerians Will Eat Themselves

Public Spending Cuts in a Great Recession

The Left, Elections and Macroeconomics

27 thoughts on “What Everyone Should Know About Budget Deficits and Public Debt

  1. Excellent and informative post on deficits. I’m looking into MMT at the moment and I’ll admit that its growing on me. I still haven’t quite gotten my head around it, but it certainly has some key lessons for our economy.

  2. Glad you found it useful. I just took a quick glance at your blog and intend to return to it later. Looks excellent. I notice you are Keynes influenced. You probably realize this already, but Keynes and MMT go together very nicely. Most of the MMTers consider themselves Post Keynesians. Bill Mitchell would be the notable exception, citing Kalecki and Marx, but the basic positions arrived at end up the same.

  3. Pete,

    Interesting speculation about the new Coalition government:

    “For the best part of five years, the Coalition admonished the Rudd/Gillard Labor Governments over their Budget deficit and supposedly excessive and wasteful stimulus in the wake of the Global Financial Crisis, instead advocating for tough spending cuts in order to return the Budget to surplus sooner.

    “Now, the Coalition appears to have performed a backflip on that position and is planning to launch a large stimulus package of its own in a bid to offset the hit to growth and employment as the once-in-a-century mining investment boom unwinds.”
    http://www.macrobusiness.com.au/2013/09/joe-hockey-lord-of-the-stimulus/

    Another interesting comment in that piece:

    “Political bastardy aside, this is a sensible policy shift from the Coalition.”

    The only thing missing is something like: “And Labor (in particular Wayne Swan) let themselves be fooled by all the SORE+ talk”.

    =========

    I am more cautious: seeing is believing.

  4. Decent post, Peter. A few notes:

    Your unusual approach to the systemization of the capitalist hegemony addresses a surprisingly underexamined subject. Seemingly, the culture of the public sphere may be parsed as the ideology of power/knowledge. But the somewhat unsophisticated parody of the relationship between the poetics of the nation-state and the formation of localized small-group cultures may seem impressive only to the uninitiated. Fortunately, your suggestive but frustratingly incomplete analysis of the illusion of praxis is sure to stimulate much future work on the subject.

    So try to work on that. Otherwise, everything else looks great!

  5. Peter,

    Great post as usual.

    However I think the job for this season is to try and come up with a narrative that explains this system to the ordinary Joe who is somewhat hard of accounting.

    And that means stepping outside the usual MMT description of things and slightly towards the way the ordinary Joe sees things.

    For example rather than issuing public debt instruments, the government should just borrow directly from the Central Bank on an overdraft.

    After all if the Central Bank is deemed capable of setting an appropriate interest rate and overdraft limit for the entire economy, surely it is capable of setting an appropriate interest rate and overdraft limit for a mere government.

    That then means that the interest rate the government pays and the interest that the private sector receives on their savings can be different – as determined by the Central Bank.

  6. Magpie, the thought has occurred from time to time that the Republicans in the U.S. might take a similar tack when one of theirs makes it back into the White House. It wouldn’t surprise me. In the case of Australia, Labor might try to make mileage out of the backflip but I reckon if the Coalition took this course the deficit would quickly become a non-issue politically, barely discussed.

    Trixie: There must be a place for you somewhere in a university. Your literary criticism is sublime. Once football season has past, I may spend a lazy Sunday morning sipping coffee and savoring each nuanced turn of phrase in that brief gem.

    Neil: Good thoughts. Thanks.

  7. Peterc, glad you like my blog and yes I would consider myself a Keynesian. I have indeed noticed a very strong overlap between Keynesian and MMT economics. Doesn’t MMT have in roots in one of Keynes’ writings? (ON the Treatise of Money I think) On policy debates at the moment we are both on the same side with both sides emphasing the need to run budget deficits in order to reach full employment..

    As far as I can tell, (while simplifying of course) the main difference seems to be that Keynesians aim for a long run budget surplus, whereas MMTers do not.

  8. @Robert Nielsen

    My understanding is that MMT does not “aim” for a budget deficit or surplus per se, but says that it should be allowed to float as needed to attain real macroeconomic goals such as Full Employment, Price Stability, and Economic Growth.

  9. Not to mention that everybody aiming for a Budget Surplus would be a fallacy of composition. So that can’t be what Keynesians are aiming for, unless they’ve misunderstood the General Theory.

  10. This is a very helpful article, giving the most complete explanation I’ve seen in terms that I can understand of how MMTers view the role of deficits/surpluses in our economy.

    There does appear to be a flaw, however, in the idea that adding money to the economy will result, at some point, in full employment.

    The theory goes that we have a limited appetite for financial assets (so-called “savings”) and when that appetite has been sated we will spend into the productive economy, which will create employment for all of those who want it.

    What I see instead is an insatiable desire for hoarding money. We measure our security, wealth, power and status by how much money we “have”, which drives us all towards holding as many financial assets as we can accumulate.

    Whenever new money is added to the economy by whatever means (government issue or bank credit) most of it ends up being captured (as profits or surplus income) and hoarded.

    This leaves the productive economy perpetually short of money for investment and consumption.

    Attempting to cover this shortfall by issuing more money through government spending might give the productive economy a little boost for a short while but it will soon fizzle out as most of the new money is captured and hoarded.

    In short, increasing the deficit will never, in the long term, lead to full employment. All it will do is add to the hoards of money and other stagnant financial assets.

    I can see two significant dangers in these huge reservoirs of hoarded money.

    Firstly, the interest payments that are due on all of the issued money have to be made (ultimately) out of the productive economy, which further depletes the amount of money that’s available for commerce. At some point (and it might not be far away) interest payments on public and private debt will overwhelm the productive economy and the whole thing will grind to a halt.

    Secondly, if the productive economy is unable for any reason to supply enough of the necessities of life to meet the needs of all of the population, the price of these necessities will rise very rapidly as people who have hoards of money compete to get hold of the stuff that’s scare. Galloping inflation will ensue, which will quickly make those who have little or no hoarded money utterly destitute.

    There are ways to fix these problems but increasing deficits is not one of them.

  11. @ Malcolm

    You apparently think that MMT economists have not thought of the obvious objections and met them.

    1. No problem if the interest rate is lower than growth rate and the central bank sets the rate. See, for example, Scott Fullwiler, “Interest Rates and Fiscal Sustainability,” which shows that is no intertemporal government budget constraint.

    2. If demand exceeds the capacity of the economy to expand to meet it at full employment, then raise taxes. See Abba Lerner on “functional finance.” This is what a progressive income tax does pro-cyclically anyway, or is supposed to do if structured correctly, which the privileged class resists using their political clout

    This brings me to the point you don’t mention and which is the most salient one in my view. Hoarded wealth, which accumulates at the top, increases the political power and influence of the elite and confers privilege resulting in a plutocracy and leads to economic inequality that distorts the economy as well, eventually leading to social unrest. Without getting a leash on power by getting the money out of politics and ending legalized bribery and locking the revolving door, not much can be done politically. Most of our economic problems stem from neoliberal politics propagandized by the elite for their advantage.

    The point of fiscal policy is to maintain the circular flow of the economy at optimal output, full employment, and price stability by offsetting demand leakage to saving, both from the domestic private and external sectors. MMT shows how to do that in considerably more detail than Peter has been able to included in the scope of this post, which simply sketches the outlines for intelligent voters. Of course, there is a lot more detail to flesh out, which MMT economists have done in the literature.

  12. “If demand exceeds the capacity of the economy to expand to meet it at full employment, then raise taxes.”

    And of course constrain the banks so that lending is directed solely towards the capital development of the economy.

  13. While agreeing with Tom and Neil’s responses, I think Malcolm’s comment touches on a few points that are not often discussed. The points certainly were not covered in my present post which, as Tom says, was limited in scope to explaining the lack of a revenue constraint on government. I do think there is confusion in the general community on that issue.

    Together with the points mentioned by Tom and Neil, I would briefly add the following:

    – For MMTers, the preferred means of ensuring full employment (along with price stability) is the job guarantee. This policy would ensure full employment irrespective of the size of the budget deficit.

    – The effectiveness of fiscal policy does depend on distributive factors. If the government just made massive transfers to plutocrats who have little intention of spending on goods and services, the policy would simply give that cohort a greater nominal claim on the nation’s real wealth, which I agree would be crazy. If instead the spending is directed toward productive activity or involves transfers to lower and middle income groups with high propensities to consume, the impact on output and employment will be greater. But that is not to say that saving should not also be enabled. At the moment, many are over indebted and the saving is necessary to meet debt obligations (unless of course there is an orderly write down or cancellation of the debts, which I would be in favor of).

    –Taking the previous two points together, bottom-up fiscal strategies will be the more effective. Getting income directly into the hands of those who are most likely to spend it is best.

    – The MMT observation that unemployment occurs (in the absence of a job guarantee) when the budget deficit is insufficient to enable the non-government’s intended surplus is referring to the non-government’s intended surplus at full employment output. For example, if the non-government’s intended surplus amounts to 8 percent of the full-employment level of GDP, then it follows that the budget deficit will need to be 8 percent of full-employment GDP to eliminate unemployment. If the budget deficit is smaller than this, negative-income adjustments will cause GDP to fall short of the full-employment level as the non-government attempts to achieve its intended surplus.

    – The non-government’s intended surplus at full-employment GDP is not infinite. Income is desired not only to accumulate nominal savings (claims on real wealth) but to accumulate real wealth (requiring investment) and to consume. Normally the non-government has chosen to maintain a moderate surplus. This makes sense considering the uncertainty and insecurity inherent in the present economic system. But a non-government surplus is not inevitable, as the immediate lead-up to the current crisis demonstrated.

  14. “If the government just made massive transfers to plutocrats who have little intention of spending on goods and services, the policy would simply give that cohort a greater nominal claim on the nation’s real wealth, which I agree would be crazy.”

    Isn’t that a description of the government bond market?

  15. Isn’t that a description of the government bond market?

    Dum-dum-dummmm.

    (Worst.Communist.Ever)

    Distribution matters. And if we’re too stupid to do it the easy way (or prevent it from occurring in the first place), then it will just resolve itself the old-fashioned way: pitchforks and torches.

  16. Peter, while I agree that government top line spending targeted toward the bottom is most likely to get spent, that consists mostly of transfers and maybe tax cuts for the middle class like the temporary payroll tax suspension in the US.

    However, most government investment in a developed economy goes mostly toward the top right off, and in the end, all money flows either to government through taxes or to the top of the town where it is saved. As Bill Mitchell often says and Neil alludes to above, the deficit is saved as the offset in tsys and they are held mostly at the top and externally, resulting in an interest subsidy for trade deficits and corporations that is unnecessary operationally under the existing system.

    And as Michael Hudson notes, what is not taxed away is goes eventually to rent. So without substantial progressive taxation and doing away with the interest rate subsidy, “the lower classes” are at a disadvantage before the deficit is even spent, since income and wealth inequality will inevitably result.

  17. Re the ‘Framing’ only :

    “Credulity from Ignorance of Nature
    Ignorance of naturall causes disposeth a man to Credulity, so as to believe many times impossibilities: for such know nothing to the contrary, but that they may be true; being unable to detect the Impossibility. And Credulity, because men love to be hearkened unto in company, disposeth them to lying: so that Ignorance it selfe without Malice, is able to make a man bothe to believe lyes, and tell them; and sometimes also to invent them.”

    Excerpt From: Hobbes, Thomas. “Leviathan.” 1651.

  18. What constrains the Federal Government from simply building up a huge overdraft in its account at the Fed, as was suggested by one of the commenters?

  19. Hi Bill. It’s a self-imposed operational constraint. The government currently forbids the US Treasury from borrowing directly from the Fed. Instead, the Treasury has to do so indirectly via the open market. The result is much the same except for the corporate welfare that comes with it (interest payments to non-government that otherwise would have been returned from the Fed to the Treasury if the process was direct). Whether the self-imposed constraint is motivated primarily by this, or by a misconception that it actually poses a revenue constraint on government, or by a desire to create that impression falsely within the general community is unclear.

    During some periods in the past, direct borrowing was permitted. Marriner Eccles argued for this to be continued in a 1947 House of Reps Hearing. His argument is worth checking out, if you haven’t previously.

    Mariner Eccles March 1947 Hearing

  20. Great paper. Relevant excerpt (p. 8):

    Mr. SPENCE. I assume the reason the authority was repealed in
    1935 [allowing overdrafts] was because of the existing conditions, then, when there was no reason for the authority: is that correct?
    Mr. ECCLES. Well, as I remember the discussion—and I have referred to it in this statement—there was a feeling that this left the door wide open to the Government to borrow directly from the Federal Reserve bank all that was necessary to finance the Government deficit, and that took off any restraint toward getting a balanced budget.
    Of course, in my opinion, that really had no relationship to budgetary
    deficits, for the reason that it is the Congress which decides on the
    deficits or the surpluses, and not the Treasury. If Congress appropriates more money than Congress levies taxes to pay, then, there is
    naturally a deficit, and the Treasury is obligated to borrow. The
    fact that they cannot go directly to the Federal Reserve bank to borrow does not mean that they cannot go indirectly to the Federal
    Reserve bank, for the very reason that there is no limit to the amount
    that the Federal Reserve System can buy in the market. That is
    the way the war was financed.
    Therefore, if the Treasury has to finance a heavy deficit, the Reserve
    System creates the condition in the money market to enable the borrowing to be done, so that, in effect, the Reserve System indirectly
    finances the Treasury through the money market, and that is how the
    interest rates were stabilized as they were during the war, and as
    they will have to continue to be in the future.
    So it is an illusion to think that to eliminate or to restrict the direct borrowing privilege reduces the amount of deficit financing. Or that
    the market controls the interest rate. Neither is true.

  21. I don’t understand the sustainability of this system. You make it sound simple, but from the decisions and actions of those in government, it doesn’t seem to match up, the theory and the actuality.

    I’m not a economics mind, I’m closer to the “average Joe” in my understanding of economics. Maybe a little above average, but not by much. I don’t understand what is meant by “The government is the sole creator and destroyer of its own money. It creates money when it spends and destroys money when it taxes.”

    Is that meaning that when the government spends, it gives out money into the public, and that when it taxes it’s removing the money from the public back into itself? Does that mean that if a government has money, and this money is “destroyed”, that it no longer exists until it’s back into public circulation? I don’t understand how it is destroyed, it still exists, but somewhere different. And, if governments can create and destroy money easily, why is there so many issues when it comes to government finances? How can a city like Detroit go bankrupt if it has such a monopoly on money?

    The government can create money, but what actual value does it have? From my understanding, the lowering of a currency is the reason why governments don’t print an unlimited amount of money. Does the money have value because the government declare it to have and society agrees, or because there’s something backing up the value of the money?

    If the government’s meaning of debt is difference to household debt, how did Greece, Spain, Detroit etc go into bankruptcy and have such problems? What you say sounds simple, but looking at real world examples it seems far from simple.

  22. Hi Aaron. To start with your last question first, Greece, Spain and Detroit are all mere users of a currency, not issuers of a currency. Many, but not all, national governments are currency issuers (e.g. the federal government in the US, national governments in the UK, Japan, Canada, Denmark, and most other nations). However, member governments of the European Monetary Union are not currency issuers. They gave up their sovereignty when they agreed to use the euro issued by the European Central Bank, and so are revenue constrained. (Bad move.) State and local governments in federal systems are also just currency users, and so revenue constrained. These 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 in return for funding.

    Referring back to your initial question, yes, in the case of a currency-issuing government, its spending creates financial assets out of nothing (ex nihilo), and taxes destroy them. 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.

    As mentioned in the post, 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. 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.

    The viability of a currency depends on people desiring to obtain it. For government money, this is achieved by imposing and successfully enforcing an obligation on some or all citizens that is denominated in the government’s own unit of account. In modern times, taxes play the main role, but fines, fees and other obligations play a similar function. By requiring the payment of taxes 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 pressure. 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 require a budget deficit. The greater the desired non-government surplus, the greater the budget deficit can be without creating inflationary pressure. That’s not to say that any kind of non-government surplus is desirable or should be accommodated. A large intended non-government surplus may partly reflect income inequality, and policies may be needed to address that.

    There is more to it, but that is a brief rundown. The posts linked to below provide more details on various aspects. The first includes a brief description of a parable of tax-driven money. The second post discusses a somewhat more elaborate parable. The third outlines an approach to currency value. The last two elaborate on the connection between currency value, inflation, productivity and distribution.

    MMT in Simple Parables

    Parable of a Monetary Economy

    Value of the Currency

    A Short Note on the Currency

    Currency Value, Inflation, and Income Distribution

  23. Re hoarded wealth, it’s worthwhile assessing why people would choose to hoard money rather than spend it. I wonder what proportion of savings is an investment in social security, i.e. pensions, potential unemployment, “saving for a rainy day”, etc. But this is a reflection of our current social insecurity. Improve social security, and the need to save is reduced.

  24. Yep, good point, gastro george. I agree that the institutional framework, public-private mix in the economy and government policy would all influence the desired surplus of the non-government and saving behavior in particular.

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