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Deficit Spending 101


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I know how much you all love a bit of MMT :P , so I thought I'd share this synopsis from Prof Bill Mitchell. It is a little long (2,000 words approx) but is short by his standards and accessible. I am interested it what some of m'learned friends make of it and would like to hear some reasoned rebuttals. Without wanting to sound arsey, could people please read it in its entirety before commenting. Cheers! I have split it into two quotes so as to fit the diagram easily.

A lot of people E-mail and ask me to explain why we should not be worried about deficits and why they do not have to be financed by debt (even if the government does typically increase its debt when it goes into deficit). So in the coming weeks I will write some blogs to explain these tricky things. First, I will explain how deficits occur and how they impact on the economy. In particular, we have to disabuse ourselves of the notion that when governments deficit spend they automatically have to borrow which then places pressure on the money markets (which have limited funds available for lending) and the rising interest rates squeeze private investment spending which is productive. This chain of argument is nonsensical and is easily dismissed. So this is Deficits 101. Next time I will detail the reason why the central bank issues bonds (government debt).

You can use the following diagram to trace through the argument. I suggest you click on it to show it in a new window and then print it and have it beside you as you read the discussion. If you are interested in a more detailed and academic discussion of these issues then I suggest you read my latest book Full employment abandoned: shifting sands and policy failures (with Joan Muysken) which was published by Edward Elgar in 2008.

essential_government_non_government_relations.jpg

Budget deficits or surpluses occur in a modern monetary economies. A modern monetary economy such as Australia and almost every major economy has four essential features:

  • A floating exchange rate, which frees monetary policy from the need to defend foreign exchange reserves;
  • Modern monetary economies use money as the unit of account to pay for goods and services. An important notion is that money is a fiat currency, that is, it is convertible only into itself and not legally convertible by government into gold, for instance, as it was under the gold standard.
  • The sovereign government has the exclusive legal right to issue the particular fiat currency which it also demands as payment of taxes – in this sense it has a monopoly over the provision its own, fiat currency.
  • The viability of the fiat currency is ensured by the fact that it is the only unit which is acceptable for payment of taxes and other financial demands of the government.

The diagram depicts the essential structural relations between the government and non-government sectors. First, despite claims that central banks are largely independent of government, there is no real significance in separating treasury and central bank operations. The consolidated government sector determines the extent of the net financial assets position (denominated in the unit of account) in the economy. For example, while the treasury operations may deliver surpluses (destruction of net financial assets) this could be countered by a deficit (of say equal magnitude) as a result of central bank operations. This particular combination would leave a neutral net financial position. While the above is true, most central bank operations merely shift non-government financial assets between reserves and securities, so for all practical purposes the central bank is not involved in altering net financial assets. The exceptions include the central bank purchasing and selling foreign exchange and paying its own operating expenses. While within-government transactions occur, they are of no importance to understanding the vertical relationship between the consolidated government sector (treasury and central bank) and the non-government sector. We will consider this claim more closely in a future blog.

Second, extending the model to distinguish the foreign sector makes no fundamental difference to the analysis and as such the private domestic and foreign sectors can be consolidated into the non-government sector without loss of analytical insight. Foreign transactions are largely distributional in nature.

As a matter of accounting between the sectors, a government budget deficit adds net financial assets (adding to non government savings) available to the private sector and a budget surplus has the opposite effect. The last point requires further explanation as it is crucial to understanding the basis of modern money macroeconomics.

While typically obfuscated in standard textbook treatments, at the heart of national income accounting is an identity – the government deficit (surplus) equals the non-government surplus (deficit). Given effective demand is always equal to actual national income, ex post (meaning that all leakages from the national income flow is matched by equivalent injections), the following sectoral flows accounting identity holds

(G-T) = (S-I) – NX

where the left-hand side depicts the public balance as the difference between government spending G and government taxation T. The right-hand side shows the non-government balance, which is the sum of the private and foreign balances where S is saving, I is investment and NX is net exports. With a consolidated private sector including the foreign sector, total private savings has to equal private investment plus the government budget deficit.

In aggregate, there can be no net savings of financial assets of the non-government sector without cumulative government deficit spending. In a closed economy, NX = 0 and government deficits translate dollar-for-dollar into private domestic surpluses (savings). In an open economy, if we disaggregate the non-government sector into the private and foreign sectors, then total private savings is equal to private investment, the government budget deficit, and net exports, as net exports represent the net financial asset savings of non-residents.

It remains true, however, that the only entity that can provide the non-government sector with net financial assets (net savings) and thereby simultaneously accommodate any net desire to save (financial assets) and thus eliminate unemployment is the currency monopolist – the government. It does this by net spending (G > T). Additionally, and contrary to mainstream rhetoric, yet ironically, necessarily consistent with national income accounting, the systematic pursuit of government budget surpluses (G < T) is dollar-for-dollar manifested as declines in non-government savings. If the aim was to boost the savings of the private domestic sector, when net exports are in deficit, then taxes in aggregate would have to be less than total government spending. That is, a budget deficit (G > T) would be required.

So how do deficits arise? How does the Federal government spend?

The Federal government has cash operating accounts – to ensure that they can spend (G) on a daily basis and receive daily receipts (T). The Reserve Bank of Australia (RBA) “provides a facility to the Australian Government that is used to manage a group of bank accounts, known as the Official Public Account (OPA) Group, the aggregate balance of which represents the Government’s daily cash position.” (see details here).

When the Federal government spends it debits these accounts and credits various bank accounts within the commercial banking system. Deposits thus show up in a number of commercial banks as a reflection of the spending. It may issue a cheque and post it to someone in the private sector whereupon that person will deposit the cheque at their bank. It is the same effect as if it had have all been done electronically.

All federal spending happens like this. You will note that:

  • Governments do not spend by “printing money”. They spend by creating deposits in the private banking system. Clearly, some currency is in circulation which is “printed” but that is a separate process from the daily spending and taxing flows;
  • There has been no mention of where they get the credits and debits come from! The short answer is that the spending comes from no-where but we will have to wait for another blog soon to fully understand that. Suffice to say that the Federal government, as the monopoly issuer of its own currency is not revenue-constrained. This means it does not have to “finance” its spending unlike a household, which uses the fiat currency; and
  • Any coincident issuing of government debt (bonds) has nothing to do with “financing” the government spending – again this will be explained in a further blog.

All the commercial banks maintain accounts with the RBA which permit reserves to be managed and also allow the clearing system to operate smoothly. These so-called Exchange Settlement Accounts or Reserves always have to have positive balances at the end of each day, although during the day a particular bank might be in surplus or deficit, depending on the pattern of the cash inflows and outflows. There is no reason to assume that these flows will exactly offset themselves for any particular bank at any particular time.

In addition to setting a lending rate (discount rate), the RBA also sets a support rate which is paid on these commercial bank reserves. Many countries (such as Australia, Canada and zones such as the European Monetary Union) maintain a default return on surplus reserve accounts (for example, the RBA pays a default return equal to 25 basis points less than the overnight rate on surplus Exchange Settlement accounts). Other countries do not offer a return on reserves which means persistent excess liquidity will drive the short-term interest rate to zero (as in Japan until mid 2006) unless the government sells bonds (or raises taxes). The support rate becomes the interest-rate floor for the economy. We will investigate this in a further blog.

So Federal spending by the Treasury, for example, amounts to nothing more than the Treasury debiting one of its cash accounts (say by $100m) which means its reserves at the RBA decline by that much and the recipient deposits the cheque for $100m in their private bank and its reserves at the RBA rise by that amount.

Taxation works exactly in reverse. Private bank accounts are debited (and private reserves fall) and the government accounts are credited and their reserves rise. All this is accomplished by accounting entries only. The taxation does not go anywhere! It is not stored anywhere and certainly does not “finance” the spending. The non-government sector cannot pay its taxes until the government has spent! It is a good practice to think of taxes as just draining liquidity from the non-government sector reflecting the Government’s desire for that sector to have less spending capacity.

A simple example helps reinforce these points. Suppose the economy is populated by two people, one being government and the other deemed to be the private (non-government) sector. If the government runs a balanced budget (spends 100 dollars and taxes 100 dollars) then private accumulation of fiat currency (savings) is zero in that period and the private budget is also balanced.

Say the government spends 120 and taxes remain at 100, then private saving is 20 dollars which can accumulate as financial assets. The corresponding 20 dollar notes have been issued by the government to cover its additional expenses. The government may decide to issue an interest-bearing bond to encourage saving but operationally it does not have to do this to finance its deficit. The government deficit of 20 is exactly the private savings of 20.

Now if government continued in this vein, accumulated private savings would equal the cumulative budget deficits. However, should government decide to run a surplus (say spend 80 and tax 100) then the private sector would owe the government a net tax payment of 20 dollars and would need to sell something back to the government to get the needed funds. The result is the government generally buys back some bonds it had previously sold. The net funding needs of the non-government sector automatically elicit this correct response from government via interest rate signals.

Either way accumulated private saving is reduced dollar-for-dollar when there is a government surplus. The government surplus has two negative effects for the private sector:

  • the stock of financial assets (money or bonds) held by the private sector, which represents its wealth, falls; and
  • private disposable income also falls in line with the net taxation impost. Some may retort that government bond purchases provide the private wealth-holder with cash. That is true but the liquidation of wealth is driven by the shortage of cash in the private sector arising from tax demands exceeding income. The cash from the bond sales pays the Government’s net tax bill. The result is exactly the same when expanding this example by allowing for private income generation and a banking sector.

From the example above, and further recognising that currency plus reserves (the monetary base) plus outstanding government securities constitutes net financial assets of the non-government sector, the fact that the non-government sector is dependent on the government to provide funds for both its desired net savings and payment of taxes to the government becomes a matter of accounting.

Next time I will trace the impact of a budget deficit on the bank reserves and dispel the myths about borrowing and interest rates (that deficits drive up interest rates).

http://bilbo.economicoutlook.net/blog/?p=332

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It seems to be quite a long article that merely sets out how the basic transactions between the government and private sectors can be considered as a simplified schema, so there isn't really much to say about it. The general tone of the article seems to imply that government deficits are a good and necessary thing though, and although the restrictions may be cleared up in 102 and subsequent elucidations,I assume that was what you wished to discuss.

It highlights that government spending and taxation are achieved by accounting entries in banks and not by actual flows of physcal cash. I'm not sure of the relevance as this is exactly the same for most businesses, but it's useful to bear in mind.

It implies that both taxation and bonds are irrelevant to funding government expenditure, but that bonds can encourage saving. I don't quite understand the logic there as it has already emphasised that goverment deficits automatically create private savings. ( I guess also bonds can be used to influence monetary conditions, interest rates etc). It doesn't comment on the logic of taxation, but presumanly that is just necessary to redistribute wealth and make society fairer.

It downplays the importance of the overseas sector.

[Just another thought] The simplified logic would lead to the conclusion that, the bigger the government deficit, the richer we all become, and that we don't have to bother with all that education, and making stuff, or anything. Just sit back and enjoy the wealth created by the government presses.

Just my thoughts so far. Again, there doesn't seem to really be anything specific to discuss as it is really just background information.

Edited by BigPig
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It's strange that people accept the assumption that the 'government sector' is something magical, which floats above the rest of the other entities in the chart.

It's also strange that people accept the assumption that it is ok for said magical organisation to use violence to maintain control, via a monopoly on money, at all.

Also strange is how such believers in this magical system, also think that savings can only occur in the (literal) monopoly money which the government produces. It's as if any other assets are wished away, in order to believe that the model works and is necessary.

I'm sure the individual who wrote the article is intelligent, but I have to wonder why they don't ask why the system works in the way they describe, rather than just illustrating how it works.

Putting an organisation on a magic pedestal and calling it the 'government sector', while discussing 'taxation', is just legitimising the theft and violence, which allow the hierarchy to function at all.

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  • 2 weeks later...

Thank you for your explanation.

I'm afraid I disagree with MMT from the start, deficits do matter, the two key ingredients of every hyperinflation in history have been a fiat currency, and large government deficits (funded by excessive currency issue).

I've seen MMT supporter comments on this before, and through the MMT formula it is claimed that excess currency issue can be removed from the economy by taxation, although I'm not convinced this is true, simply because governments are almost always printing money because they cannot tax excessively without either becoming massively unpopular or by destroying tax revenues (nor are they able to issue excessive amounts of bonds on the open markets without pushing yields up, and therefore resort to rigging the market by purchasing new bonds with further issues of currency).

MMT adherents also seem to blame hyperinflation on wars and other adverse avents, but these things often occur because governments use money printing to enable them to make extreme policy decisions, without any consent or oversight (i.e. by increasing taxation or by issuing further bonds on the open market).

I also disagree with the idea in MMT that savings consist purely of pieces of paper issued by the government, I agree that people use these pieces of paper as proxy for saving, but saving can and does occur independently of this (the act of deferring consumption is saving), even in within the jurisdiction of a government that issues fiat currency, and like I said before inflation exposes the fragility of peoples' perceptions, otherwise prosperity would be proportional to the amount of currency issued (which just isn't so).

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