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, financial affordability is not an issue for currency-issuing governments and there is 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.
The governments of most nations, including the US, can never run out of money. They issue their own currencies. Exceptions are the governments of eurozone countries, who are mere users of a currency (the euro), rather than issuers of a currency. Lower levels of government – such as state and local governments – are also mere currency users, rather than currency issuers.
The fact that a currency-issuing 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 fiscal deficits and surpluses need to be thought about in a different way than most 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 features:
1. The government is the sole creator and destroyer of its own money. It creates money in the act of spending and destroys money in the act of taxing.
2. The exchange rate of the currency is allowed to float. 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 methods of initial finance. 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 or public health care might be unaffordable due to a lack of money, when in reality only a lack of real resources could make these policies unaffordable.
For a currency sovereign such as the US federal 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 bonds could be purchased by non-government.
Creation and destruction of government money
A currency-issuing government creates ‘government money’ when it spends or lends. Spending and lending operations are conducted through the government’s agents, specifically its fiscal and monetary authorities. Government spending entails coordination between the fiscal authority (e.g. Treasury) and monetary authority (e.g. central bank). Government lending is conducted by the monetary authority.
Government money takes two basic forms: ‘currency’ and ‘reserves’. Currency comprises notes and coins. Reserves are funds held by banks in special accounts at the central bank. They are used for the final settlement of transactions.
The process of government spending entails the fiscal authority instructing the monetary authority to credit the reserve accounts of the banks at which spending recipients have accounts. The monetary authority, in turn, instructs the banks to credit the accounts of spending recipients. In this way, government spending adds reserves to the banking system. Depending on institutional arrangements, the reserves may simply remain in the banking system, with interest paid on reserves, or the reserves may be exchanged for government bonds.
Taxation reverses the government spending operation. It involves the debiting of both reserve accounts and private bank accounts. Taxpayers instruct their banks to delete funds from the appropriate accounts and the banks, in turn, instruct the central bank to delete funds from the appropriate reserve accounts.
Non-government cannot pay taxes or purchase government bonds until government money has been created. Government money is created through government spending or lending. However, only government spending enables non-government to eliminate its financial liabilities to the state.
Government lending involves the central bank adding reserves to reserve accounts. So, government lending does create government money in the form of reserves. However, unlike government spending, which issues currency free and clear, government lending leaves non-government liable to repay the loan. Usually, government lending is collateralized, such that the borrower (a bank) needs to supply government bonds in exchange for the reserves added through government lending. These government bonds can only be held by non-government because of previous rounds of government spending, which, by creating government money, enabled non-government to purchase the bonds. Even in the event of uncollateralized loans (an uncollateralized overdraft on a bank’s reserve account, with a penalty attached), the liability of non-government to government created by the imposition of a tax is not finally extinguished until the overdraft is eliminated, and this can only be done with government money (debiting of a reserve account).
So, as a matter of logic, government spending is prior to taxation and public borrowing. Taxes and public borrowing do not – and literally could not – provide the initial finance for government spending or public lending. It is the other way round.
Creation and destruction of net financial assets
In aggregate, net financial assets comprise the sum of currency on issue, reserve balances and outstanding government bonds. The reason is that all other financial assets – non-government financial assets – are matched by non-government 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 non-government as a whole.
Considered in isolation, government spending creates reserves, and so adds to the net financial assets held by non-government. Taxation, considered in isolation, drains reserves, which destroys net financial assets.
A fiscal deficit occurs when the government spends more than it taxes. The net result is an overall increase in financial assets held by non-government. In other words, fiscal deficits increase net financial assets. Fiscal surpluses do the reverse, and balanced budgets keep the level of net financial assets constant.
Under current practice, many national governments match any deficit with “borrowing” by issuing government bonds (public debt). In effect, the extra bank reserves created by the fiscal deficit are exchanged for government bonds. The net impact is that 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 bonds 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 bonds by crediting reserve accounts, thereby expanding the amount of reserves in the system (referred to as quantitative easing).
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 non-government into government bonds. Quantitative easing does the reverse, with the central bank purchasing bonds in the secondary market and paying by crediting reserve accounts. Since both reserves and government bonds are financial assets of non-government, switching between them does not affect the non-government’s total holdings of net financial assets.
The common practice of matching fiscal deficits with public debt is unnecessary. Rather than issuing bonds, governments could simply allow the extra financial assets to remain in the form of reserves and pay the target rate of interest on reserves. This would make it more obvious to the electorate that bond sales play no financing role.
In any case, whether the government issues bonds or not, the economic impact of the fiscal deficit will be the same. 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, non-government might prefer to increase its 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 fiscal deficits enable both.
Real resources, not finance, are the constraint on currency-issuing government
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 entirely different in the case of a currency-issuing government. It can never become impossible for such a government to make its debt repayments. A currency-issuing government does not need to obtain tax revenue in order to make payments. It does not need nor benefit from prior “savings” in its own currency. 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.
The role of taxation
All this raises a question. If taxes do not provide the initial finance for government spending, why are they necessary?
At the most fundamental level, it is the enforcement of taxes denominated in the government’s unit of account that ensures a demand for the government’s money. By enforcing a tax obligation that can only be extinguished (i.e. finally settled) in the government’s own money, 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.
The sectoral balances and financial sustainability
In addition to making tax payments, many of us in the private sector desire to save in the national unit of account. To the extent that the community’s saving desire reflects extreme income inequality – high-income households tend to save at a higher rate than others – a high-saving rate may indicate a need to redress income inequality. However, even when income is well distributed, it is likely that non-government in aggregate will wish to spend less than its income as a protection against future uncertainty. The reverse situation, in which non-government spends more than its income, is financially unsustainable because it tends to push households increasingly into debt, intensifying the risk of financial crisis.
In aggregate, it is only possible for non-government to spend less than its income – that is, to maintain a financial 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
For a given distribution of income, fiscal deficits will be required whenever private domestic spending and export demand are insufficient to ensure healthy levels of economic activity. In particular, the presence of unemployment indicates that we intend to save more and spend less than is consistent with full employment.
Currency-issuing government is in a unique position to alter the capacity of the private sector to spend and save. By increasing government spending, cutting taxes, or some combination, the government enables both extra spending and extra 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 private spending power and leave more room for non-inflationary public expenditure.
This is just another way of saying that the constraint on government spending is 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 first increasing tax rates.
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 are without basis. 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. This does not preclude introducing much higher taxes on incomes and wealth above certain thresholds. It just needs to be understood that the purpose of such tax measures would be to redress inequalities of income and wealth – and the deleterious effects of extreme inequalities on the functioning of democracies – and would have nothing to do with financing government spending. We do not need the money of the rich to pay for social programs. Government can create money at will.
3. A fiscal 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 either fiscal deficits are too small, inequalities are too extreme, or both.
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.
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.
Fiat Money and its Social Significance
Government Deficits and Net Private Saving
Critique of Reidl on Government Spending
Parable of a Monetary Economy
The Government is not a Household
Public Spending Cuts in a Great Recession