Part of How Money Works – FAQ

Paying for public services, in a monetary sovereign state

If our national Government was to spend more than the currently budgeted amount on your health care system next year, it would be good to know how they would finance that spending. It is a question that advocates of more health spending are always likely to be asked. More generally, exactly how is the total public spending which is currently budgeted for across the next year going to be funded? Do the various charts you see, linking the total tax take and government borrowing to items of government expenditure make any sense? If not, then why not?

The conventional view

This is that public spending must be paid for through taxation, government sales of assets, or issuing government bonds – in other words, through taxes now, ‘selling off the family silver’ now, or borrowing at interest now money which will have to be repaid in the future, and presumably setting up a burden of additional taxation for future generations.

Your reaction to this conventional answer might be a “conservative” one, which is to say, more austerity to keep government spending down and more privatisation, in order to keep taxes low: or a “progressive one”, which is to say, tax the rich and the multinationals much more highly, because the Government needs more money from rich people so it can pay for our public services.

Both of these reactions are wrong, or at least misleading, because they are based on that conventional view of public sector finance which I mentioned above. It is a conventional view which suits many conservatives, but is also (wrongly) accepted as being valid by many progressive people. It is – and this might surprise you – a view which the majority of highly credentialed economists, including Nobel Prize winners, know to be incorrect, but which many of them justify as a mechanism for imposing some restraint on politicians. They believe that if politicians knew the financial options which are actually available to them, they would abuse these freedoms, ‘spend like drunken sailors’, and wreck the economy.

Laws of Public Finance

I don’t believe there is ever a good reason for remaining in ignorance about something this important, and I think we have other ways of restricting what politicians do than telling blatant lies to the public, so I want to share the truth with you.

To keep this as brief and as straight-forward as I can, I am not going to dwell on the current institutional practices, conventions and rules, as they are applied in 2017. Current practices are very different indeed from how things were done before 1979. All the sets of conventions and rules which have been applied down the years have, to a greater or lesser extent, obscured the truth about public finance, which I can summarise in two sentences. Let’s call them two ‘laws’ of public finance (based on Lerner’s laws of functional finance, from the 1940s).

1. A government with its own currency (like the dollar), its own central bank (like the Fed or Federal Reserve), a floating exchange rate, and no foreign currency debt, faces no financial budget constraint at all.
2. Such a government faces real and ecological constraints, but no financial constraint.

Let’s be clear what we are talking about here. We are not talking about Greece. We are not talking about an independent Scotland, if Scotland were to keep the pound or join the euro (which I have recently advised a Scottish political party to stop saying they would do). We are talking about a genuine ‘monetary sovereign’. We are talking about the USA, Japan, Australia and the UK, among many others.

Monetary Sovereignty

The U.S. Government is a monetary sovereign. Every time the U.S. Government spends a dollar, it does so by crediting the reserves of a commercial bank which are held at the Fed (The USA’s central bank) by that dollar, and having the commercial bank credit the bank account of whoever has been the beneficiary of that spending. In other words, every time the Government spends, it creates money. Not some of the time – every time. All of the Government’s spending creates money, and all this money is created using the equivalent of keystrokes on a computer.

The Government does not need to receive your money in taxes, or borrow your money by selling bonds, or raise money from you by selling you shares in government owned utilities …. before it spends. Think about it for a moment. It isn’t, in a literal sense, your money in the first place. Who issues the nation’s currency? The Fed. And who owns controls the Fed? The U.S. Government. The Government doesn’t need to collect its money, which it creates, from you before it can spend.

Every time our national Government spends, it creates some of its money for the purpose. I know commercial banks create a great deal of deposits for themselves, and a great deal of what is normally defined to be ‘the money supply’ by lending to their customers, but they can only do this because they have access to Government money, in the form of their reserves at the Fed. There are two ways for this money to be created. One is the Government spending this money (permanently) into existence, and the other is the Fed lending this money (temporarily) into existence.

We have come to the answer to our initial question. How can we pay for an increase in health spending? The same way that we pay for all public spending. The Government will spend the money into existence. The way the accounting is done these days, and current institutional practices, obscure this truth, but they do not change the fact that it is a truth. It is not a theory. It is a plain fact.

Let me put it more simply. Money does not grow on trees. It is easier than that. Money comes from nowhere. It exists mainly in the form of electronic entries on spreadsheets (these days), and you can say it is typed into existence. Our Government can no more run out of dollars than the scorer at a hockey game can run out of goals, perhaps something to remember the next time, say, an American team goes to Canada to win in a hockey tournament. In this sense, the Government really does have a ‘magic pudding’.

You might ask me whether I am talking about ‘printing money’ to pay for the Government’s spending. You might conjure up visions of Zimbabwe or Weimar Germany. I’ll deal with those briefly in a footnote below, but let us be clear – in a sense, all of Government’s spending always involves ‘printing money’. Except, I hate using that term, because of its associations, and because it is a little misleading. Very little modern money is actually printed, remember – it is nearly all electronic.

The Purpose of Taxation

The question is, then, why do governments tax people at all? Taxes do not ‘pay for government spending’, after all. Taxes do not pay for the education service. Taxes do not pay for Medicare. It might make you feel better to know that your taxes are not paying for military weapons. They really aren’t. The Government doesn’t need to get money from rich people before it can spend. Your taxes, in a literal sense, do not pay for anything. Taxes, at least in a monetary sovereign state, pay for nothing at all.

So, why do we pay taxes? There are many distributional, or microeconomic, functions which the tax system fulfils. However, at the macroeconomic level, the purpose of taxation is very simple. It is necessary for people to pay taxes to destroy (to use a provocative word) some private sector spending power, to make room within the economy for the government to conduct its desired spending on public goods and services, without pushing total spending in the economy beyond the productive capacity of the economy and causing inflation. Taxes limit inflation, helping us to maintain the spending power of money, so that people maintain their confidence in the value of money.

Deficit Budgeting

We have reached the second law I wrote down above. As a society, we cannot run out of dollars, but we can run out of people, skills, technology, infrastructure, natural and ecological resources. There are limits – but the limits are ‘real’ and not financial. When planning for the future, governments should use their freedom from financial constraints to plan wisely to manage the real and ecological constraints which will always be with us.

The Government, then, cannot spend without limit, because it would push total (private sector plus public sector) spending beyond the current capacity of the economy, and be inflationary. So we have to pay taxes.

This does not, however, mean that governments need to ‘balance the budget’, or should ever attempt to balance the budget, or limit its deficit to a specific proportion of GDP. In fact, most Governments (including the U.S. Government) have hardly ever run balanced budgets or budget surpluses in modern times, and when they occurred they tended to be just prior to economic downturns. For example, there were very small and very temporary fiscal surpluses in the USA, for example, in the late 50s, the late 60s and the late 90s. The rest of the time, the U.S. Government has been in continuous fiscal deficit, since the early 1950s.

This is true almost everywhere, with almost all the exceptions being relatively small and oil rich countries, like Norway. In the case of Norway, what makes it possible for the government to run fiscal surpluses is not the ‘sovereign wealth fund’ you may have heard about. It is simply Norway’s consistently large trade surplus with the rest of the world.

Most governments most of the time historically have run budget deficits. This is essential, because if the rest of us want to build up our savings in dollars (including foreigners in ‘the rest of us’) it turns out the Government will be forced, one way or another, to run a deficit. A good deficit will prevent a recession from happening, and a bad deficit would be the consequence of a recession happening and tax receipts crashing while welfare payments rise, when everyone wants to save and not spend. To explain the logic properly would mean going into too much detail here, but believe me it is a mathematical (or accounting) fact of life.

Sovereign Government Debt is Different

Doesn’t all this mean the Government getting further and further into a burdensome ‘debt’, which future generations will have to repay, so that government borrowing is somehow immoral, and especially so if it isn’t to pay for investments in the future?

Not once you understand that monetarily sovereign governments don’t and can’t really borrow in their own currencies, at all, in the conventional sense of the term. If you or I, or a business, or a local authority, borrow in dollars, then later on we will have to repay that debt and the interest on it, or we will go broke. We are (obviously) not monetary sovereigns. We face a financing constraint.

It is different for our national Government. I have already said that the Government spends new money into circulation, and then uses taxes to destroy some of that money so that there won’t be rising inflation. Ideally, the Government should spend more than it taxes, when it is running a deficit, to ensure that total spending in the economy is at the right level to maintain full employment. The total level of public spending, how it is divided up between public goods, and the structure of the taxation necessary to limit inflation, are then political issues.

Until the Global Financial Crisis, and before some central banks started doing quantitative easing, it was necessary for their governments to sell government bonds to more or less match government spending net of taxes, in order to keep control of interest rates. The reasons are a bit dull, but if you bear with me I will try to explain.

Interest rates in general depend on the interest rate banks charge each other when they lend each other money for liquidity management purposes for very short periods of time. A fiscal deficit effectively feeds cash reserves, or liquidity, into the banking system. In the past, it was necessary to remove those reserves again by selling government bonds, or this interest rate would fall below the level the central bank wanted it to be at. Banks with plenty of reserves of cash don’t need to borrow from other banks. Sales of government bonds were about keeping the supply of cash to the banking system limited to the right level to stop interest rates falling.

That’s all changed now – at least in the UK, the USA, Japan and the Eurozone. The central banks of all those countries first cut interest rates to virtually zero, after the Financial Crisis, and then used quantitative easing to deliberately flood the banks with cash reserves, by purchasing large amounts of (mainly govern-ment) bonds from the private sector. The so-called ‘bank rate’ is now not a rate of interest at which private banks lend to each other – it is now the rate of interest that central banks pay on the huge amount of reserves the commercial banks have on deposit with it. Rather than seeking to limit those reserves, the central banks have been deliberately increasing them.

Yet the old practice of each government selling its bonds goes on. It is rather ridiculous at the moment, because as the governments concerned are selling new government bonds – in a conventional view, to raise money – their own central banks (which are owned by each government, remember) are kept busy buying those same government bonds second hand from the private sector, in order to increase the amount of money in bank reserve accounts. It’s very strange and anachronistic. Economists like me view it as something of a muddle.

We have learned in recent years that there is no genuinely good reason for selling government bonds at all, if you are a monetary sovereign government. Indeed, it would be better to convert them into term deposits at the central bank, and to regard them as a form of money.

After all, at the moment bank reserves held at the central bank are (in an accounting sense) Government liabilities, on which the central bank as part of the Government pays interest, but are not seen as Government debt: government bonds are also government liabilities, on which the central bank on behalf of the Government also pays interest, but they are seen as Government debt.

Moreover, if the central bank, as a part of QE, buys Government bonds from the private sector, it is just swapping one interest bearing government liability for another. No wonder QE doesn’t work! It isn’t ‘free money’ at all. It is basically swapping two very similar assets for each other. The private sector used to own Government bonds and receive interest. The private sector now owns reserves at the central bank, and still received interest.

Summary

Why would that arrangement act as much of a ‘stimulus’ for the economy? Why, indeed? To cut a very long story quite short:

1. When the Government spends it creates money.
2. When the Government taxes it destroys money.
3. Government ‘debt’ should not be thought of as ‘debt’ in the conventional sense at all. It is better thought of as a form of money.
4. The Government cannot run out of money, and as long as it doesn’t guarantee to convert its money at a fixed rate into anything it could run out of, it faces no financial constraints at all.
5. However it faces real and ecological constraints, because we can run out of people, skills, technology, equipment, infrastructure, natural resources, and ecological space.
6. The Government is NOT a household and NOT a business, and has nothing at all in common with a household or a business, where financial matters are concerned.
7. When progressives understand this and start framing their arguments in this light, I believe they will be able to argue their points far more effectively and persuasively, and free themselves from what are sometimes called ‘neoliberal dogmas’ (i.e. conservative and ‘new labour’ nonsense).

Understand all of this, and I think that it will change your perspective on many things. And ought to make you a great deal more confident when dealing with interviewers. If they approach you using the conventional view as a framework, remember that it is either because they have never really thought these issues through or because they are being dishonest for some reason (sometimes it is a mix of the two, and people can, of course, be dishonest with themselves, or at least suffer from cognitive dissonance).

Footnote: Mugabe’s Zimbabwe and Weimar Germany

Zimbabwe 2008 If you engage in a poorly planned and violent land reform, regardless of your motivation, there will be consequences. Zimbabwe’s govern-ment managed to wipe out its vital agri-cultural system, while at the same time alienating most high income country governments, and facing sanctions. The supply of food failed. The Government then (literally) printed vast amounts of money to buy non-existent food, and inevitably the price level sky-rocketed. Ever higher prices then led to ever more money being printed, so that at least the friends of the government and the army could be provided for. The result was hyperinflation. The lesson is that if you destroy the supply side of your economy and try to make up for it by printing loads of money, you will be able to create hyperinflation. Zimbabwe 2008 has no lessons for Australia 2016.

Germany 1923 Germany’s productive capacity had been destroyed by war and by the resolution of that war. In addition, Germany had been required to pay vast amounts of gold to its former enemies. The only way to obtain the gold was to buy it, using marks which could then only be spent into a German economy already on the brink of famine. There were some other issues, but it’s basically similar to Zimbabwe 2008. If you destroy the supply side of an economy and then print loads of money, you will push spending far beyond the productive capacity of the economy and create inflation.

Originally by Steven Hall (adapted for the US audience by Charles Como)

Adapted from Paying for public services, in a monetary sovereign state

Also here (British version.. good comments and answers at the bottom): Green Modern Monetary Theory and Practice