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
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.