Some Implications of the Expenditure Multiplier Process

A monetary economy needs spending for production and employment to occur. This is a truism. Spending equals income, by definition. One person’s purchase of a good or service is another person’s income. But it is also clear that causation, ultimately, runs from spending to income. More specifically, the creation of income requires a prior decision to spend. In a monetary economy, to paraphrase Michal Kalecki, each of us in isolation can decide how much to spend but we cannot choose the size of our income. Our personal income will depend not on our own spending but on the spending decisions of others acting somewhat independently of ourselves. Total income, of course, will depend on spending in aggregate – our own spending and the spending of others.

Although a large part of spending (endogenous spending) can certainly be considered induced out of income received, that income received is only the result of a prior decision to spend. If, conceptually, we trace the spending and income back to its original source, we find that a decision to spend must initiate the process. It is that part of spending that occurs independently of income (exogenous spending) that plays a critical role in a monetary economy. Whenever such spending occurs, it sets off a multiplier process in which further spending can be considered induced out of income. Dynamically, whenever the growth rate of exogenous spending increases (declines), the economy’s rate of growth increases (declines), other factors (propensities for income to leak from the circular flow) remaining equal.

Conceptually, in a monetary economy, the very first exogenous expenditure – and therefore the very first creation of income – must be able to occur without any recourse to prior income (meaning without recourse to savings accumulated out of prior income) simply because there would be no such prior income or savings to draw upon. In general, a decision by somebody to spend independently of income and beyond accumulated savings can be put into effect in two ways, via lending or government spending.

It is important to understand that, either way, whether through lending or government spending, the money used to undertake the spending is created ex nihilo (“out of nothing”). A bank issues a form of new money by simultaneously creating a deposit (the bank’s liability and the borrower’s asset) and a loan (the bank’s asset and the borrower’s liability). By creating the deposit, the bank not only issues new money but commits itself to making available, on the demand of the deposit holder, government money in the form of currency; currency which the bank itself cannot issue. The bank also commits itself to obtaining government money in the form of reserve balances as necessary to enable final settlement of transactions. The reason the bank is able to undertake this commitment to obtain, at the deposit holder’s convenience, government money is that the currency issuer (under present arrangements, the central bank) always stands ready to act as lender of last resort. If all else fails, the bank can obtain the necessary currency or reserve balances from the central bank, at a price and on terms of the central bank’s choosing.

If we trace the source of the commercial banking system’s access to government money, it becomes clear that it must be the central bank’s ex nihilo creation of reserve balances (the central bank’s liability and the bank’s asset). These reserve balances must ultimately be the result either of central bank lending or of government spending. The latter, assuming central bank as currency issuer, occurs either through direct central bank purchases of government debt (not currently permitted in some countries) or, more often at present, indirect central bank purchases of government debt via the open market, in which non-government purchases of government debt are enabled by a prior ‘reserve add’ (ex nihilo creation of reserve balances) by the central bank. (For an explanation of the procedures involved in government spending in the US, see here.)

For somebody to spend independently of income and in excess of accumulated savings, they must be the recipient or issuer of new money created ex nihilo. To set a monetary economy in motion, there has to be, in the initial instance, somebody willing to spend in this way, whether that somebody is a member of the non-government or the government itself. Of course, once the process is in motion, exogenous spending can be undertaken either by drawing down past income (savings) or by obtaining newly issued money.

If the non-government, in aggregate, takes it upon itself to spend in excess of income, it will go into financial deficit and the government, by accounting identity, will move into surplus, since by definition total spending for the economy as a whole must equal total income. If, instead, the government spends in excess of tax revenue, running a deficit, the non-government gets to maintain a surplus. Again, this is by definition. If a point is reached where spending of newly issued money (new debt) combined with spending out of previous income (accumulated savings) is insufficient to maintain the rate of growth of overall spending, there will be a slow down in income growth.

A government policy approach that entails budget surpluses and overly relies, for spending and income growth, on domestic-private sector deficits runs the risk of contributing to private debt problems at some point in the future. As currency users, households and businesses are likely to find, sooner or later, that they can no longer sustain spending in excess of income. A cohort – whether a portion of households, a portion of businesses or some combination – will find itself in a hole from which it is difficult or impossible to extricate itself. (For more on this point, see here.)

The domestic-private sector will be in no position to solve the problem through its own spending decisions. Attempts to meet debt servicing requirements by cutting back private spending will merely harm income growth unless government or the external sector steps in to maintain overall spending. Without government or foreigners stepping in, the domestic-private sector may well manage to reduce the level of outstanding debt, but the outstanding debt as a proportion of income will almost certainly increase, placing the sector in a worse position than before the attempts to curb spending. Conversely, the domestic-private sector, as currency user, will not be able to maintain spending in excess of income either, since that would also exacerbate the situation by adding to the already unsustainable level of debt. Clearly, the domestic-private sector is in no position to resolve the problem unless and until its debt burden is alleviated. Similar problems can arise for governments that become indebted in foreign currencies and, to that extent at least, relegate themselves to the status of currency users.

There are two ways to remove an excessive debt burden. One involves a degree of debt forgiveness or default. This can be applied in the case of privately indebted entities or governments indebted in foreign currencies. In the case of private debt, another way is more gradual and involves government taking on the role of deficit sector. Sustained net spending by government can be used to maintain income and enable saving and paying down of private debt.

Examples of the first approach abound in history and folklore. In the religious/mythological writings that tell of the trials, tribulations and triumphs of the Israelites we read of a periodic debt jubilee. This was to occur every fifty years. All debts accumulated in the previous decades were to be forgiven and land and other property returned to the original owners. One reading of these stories is that the religious or political authorities understood very well the limits of private-sector driven growth. It was understood that the process could more or less “work” on its own terms for a time but would invariably run into unsustainable debt problems, limiting at some point the private spending behavior upon which continued income growth and prosperity depended. And, of course, there are many examples in more recent times of default or forgiveness of private debt.

There are also many examples of governments becoming over indebted in foreign currencies (putting themselves in the position of a currency user) only to default or be let off the hook, including of course Germany after the second world war. Once the debts of a currency user have been defaulted upon, written down or forgiven, the currency user is once again in a position to play the role of net spender or deficit sector.

The government’s capacity to play the role of ongoing net spender is maximized when government is a sovereign currency issuer. In the case of a currency-using government, the capacity is to an extent circumscribed, though can always be accommodated by the currency issuer, albeit with a loss of policy autonomy.

The benefits of currency sovereignty for an elected government are not limited to the maximal spending and taxing powers that such autonomy affords. Such sovereignty means not only that the government can net spend as appropriate to meet the needs of private households and businesses but that it can set the terms for, and shape the context in which, private credit creation and economic activity in general takes place. In relation to private money creation, appropriate banking and financial regulations can be put in place without credible threat of rentiers sabotaging the government’s socioeconomic plans or the real economy. The government is then in charge both of its own spending and taxing as well as of the legislative and regulatory environment in which private economic activity, including private credit creation, occurs. Private banking, to the extent it remains, can be brought into closer conformity with the aims of the community.

In view of the essential role played by ex nihilo money creation in a monetary economy, a question arises as to the legitimacy of private banking relative to public money creation.

A currency-issuing government, of course, both spends and taxes. In a sense, one effect of taxation is to apply a charge for the use of government money on those who benefit from it. This taxation, in itself, enriches nobody directly. A currency-issuing government can neither increase nor diminish its financial capacity to spend in its own currency. Rather, the taxation is for public purpose. It ensures at least some demand for the government’s money and therefore at least some capacity for the government to transfer real resources from the private to public sector in order to provide various services. Tax revenue, as non-spending, creates space for this to occur in a non-inflationary manner.

Similarly, if a public bank lends at interest, the resulting interest charges function as a tax and serve much the same function as other taxes. A business that benefits from such a loan will pay an interest charge partially clawing back the benefits the business reaps, in this way freeing up space for the provision of benefits to the community as a whole.

In contrast, interest charged on private bank loans enriches private individuals courtesy of the fact that private institutions have been granted the privilege to issue new money guaranteed to be convertible at par with government money thanks to the lender-of-last-resort function of the central bank. Interest on private loans functions essentially as a private tax. As with government taxes, the recipient of a private loan pays a charge partially reflecting the benefits of obtaining access to money. But whereas government is in no way enriched financially by tax revenue (the revenue simply amounts to non-spending that frees up space for the spreading of the benefits of money creation to the community at large), private interest payments do enrich the private creditor. They add to private wealth and strengthen the command of rentiers over society’s labor time and real assets.

If, notwithstanding these considerations, we decide (as we currently do) to allow a role for private banking, there will clearly be a strong case not only for strictly specifying the purposes for which such banking can be operated but also for taxing private interest income. Otherwise, the benefits of ex nihilo money creation are captured disproportionately by private rentiers.