Daily Archives: 08/11/2010

Fiscal Sustainability 101 – Part 2a

My aim in this 3-part series (more like 8-part series) is to further advance an understanding of how a fiat monetary system operates so that readers of this blog (growing in numbers) can then become leaders in their own right and provide some re-education on these crucial concepts. So read on for Part 2.

Recall from yesterday, Fed Reserve Chairman Ben Bernanke defined fiscal sustainability:

… as achieving a stable ratio of government debt and interest payments to gross domestic product, and setting tax rates at levels that don’t impede economic growth.

Throughout Part 1 of this series I provided some hints as to what might or might not be included in a sensible definition of fiscal sustainabilty – one that is based on a thorough understanding of the way the fiat monetary system operates. Here is the list of hints developed so far in Part 1:

  • Saying a government can always credit bank accounts and add to bank reserves whenever it sees fit doesn’t mean it should be spending without regard to what the spending is aimed at achieving. To see the difference provides a vital clue as to what “fiscal sustainability” means.
  • Advancing public purpose is another component of what “fiscal sustainability” means. You cannot define it in its own accounting terms – some given deficit size relative to GDP or whatever.
  • We won’t find a definition of “fiscal sustainability” conceptualised by some level of the public debt/GDP ratio.
  • Fiscal sustainability is directly related to the extent to which labour resources are utilised in the economy. The goal is to generate full employment.
  • The concept of fiscal sustainability is not defined in terms of any notion of public solvency. A sovereign government is always solvent (unless it chooses for political reasons not to be!).
  • The concept of fiscal sustainability will not include any notion of foreign “financing” limits or foreign worries about a sovereign government’s solvency.

So it is back to the contributions to the National Journal debate to see whether we can develop any more principles that will help us define fiscal sustainability.

The next commentator come expert (not!) is Grover Norquist who is listed as the President, Americans For Tax Reform, which is a body set up at the request of Ronald Reagon and which wants small government and low taxation. He says:

Fiscal sustainability means moving from defined benefit/pay as you go/Ponzi sheme financing of Social Security and Medicare to fully funded defined contribution pensions and health care funding. This is not just a government funding problem. Private companies that have defined benefit pensions have found themselves uncompetitive compared to defined contribution pensions.

Note the household (private sector entity)-government analogy again. Flawed at its very essence but continually wheeled out by the gold standard logicians. They ought to take a break from their desk and read some history. They could focus on the 1970s and they might find out that Bretton Woods collapsed, that convertibility went with it, that fixed exchange rate regimes are mostly gone (certainly as a world standard) and all of that. Then they might understand that they just sound plain ignorant when they make these statements.

They might be better saying … well governments for political reasons – to appease the rampant neo-liberalism that they helped to create – place voluntary constraints on themselves and act as if they were still in the Bretton Wood’s era – that is, they might voluntarily impose artificial financing rules on themselves. But in reality this is a denial of the essence of the fiat monetary system that we now live in and there is thus no economic basis for these constraints. But politically we support them because they divert power to the rich and the capital classes by keeping unemployment high and they have successfully redistributed national income from the workers to profits.

If they said that I would have more respect for the honesty. Not an ounce of respect for their values. But at least this is what is actually going on. The problem is that they don’t they that. They lie and distort the public debate – through their superior access to the media etc – and make out that these voluntary restraints are in fact economic and intrinsic. You might say I have contempt for this dissembling logic!

Hint: the concept of fiscal sustainability will not include any notion of financing imperatives that a sovereign government faces nor invoke the fallacious analogy between a household and the government.

Enter Robert Reischauer, President, The Urban Institute, which is probably on the progressive side of the debate and aims to advance public policy to improve urban centres. Reischauer says:

… over the longer run, we should ask whether we want we want to live always clinging to the edge of fiscal un-sustainability or would it be better to have a public sector that is a bit further from the cliff’s edge, one more capable of responding to the inevitable economic and political crises that will occur. We have to ask at what level we want to stabilize the debt to GDP ratio: should it be at 80 percent, 40 percent, or, perhaps the 25 percent achieved in the mid 1970s?

Conclusion: we can dismiss this view immediately. Setting some debt to GDP ratio is a futile meaningless task. If you don’t want the private sector to have more financial asset choice then the sovereign government can always stop selling bonds. Simple as that. The net spending will continue as planned but the new net financial assets that are added by the deficits will still be held by the private sector – as bank reserves or in other ways they choose. The government will just deny them the ability to convert low or zero yielding bank reserves into interest-bearing government bonds.

Anytime the private sector gets sick of having this choice would be fine for any sovereign government. They can easily address the monetary implications of this (no debt issue) by just allowing the short-term interest rate to fall to zero or whatever support level the central bank pays on excess reserves. The government could easily create an equivalence between bank reserves and government debt by paying the short-term target interest rate (the central bank target) on excess overnight reserves. Then the central bank would maintain control over its monetary policy target and no public debt would have to be issued to drain the excess reserves and curtain interbank competition for overnight funds. Simple as that!

Reischauer echos the sentiments of a “deficit dove”. This search will locate my blogs where I have discussed what a deficit dove thinks. Recall these are characters who don’t intrinsically hate deficits (like some of the conservatives) but are so beguiled by the lie that we still live in a gold standard that they take a cautious approach to deficits and talk in terms of stable debt to GDP ratios – just as Bernanke note above. Many so-called progressive economists fall into this camp (unfortunately).

So we get this logic:

The higher the ratio at which stability is achieved, the larger the deficits the government can incur while keeping the ratio stable. The higher the ratio, the larger the fraction of spending devoted to interest payments and the more exposed the budget is to adverse interest rate movements and pressure from our foreign creditors. Furthermore, taxpayers already upset that they don’t get their money’s worth in services, won’t be happy campers when a growing fraction of their taxes are absorbed paying for past services — which is what interest payments represent. For these reasons, long run sustainability should involve lowering the debt to GDP ratio from the projected 80 plus percent range back to levels that are more compatible with healthy economic growth and political stability.

All the errors of logic that you can make are demonstrated here. First, the deficit-doves still invoke the notion of an a priori government budget constraint (GBC) which imposes financial limitations on the government’s ability to fulfill its socio-economic policy ambitions. Instead of attacking the use of deficits per se, as the more extreme conservatives do, the deficit-doves talk in terms of providing more room for the deficit to work but always within the constraint imposed by the debt/GDP ratio.

This commentator makes the obvious point that the more debt there is outstanding the higher will be the interest payments forthcoming. That is, the greater is the income add to the debt holders which allows them to pursue wider spending choices and underpin employment as a consequence. There is no recognition of the monetary policy imperatives (maintaining interest rate targets) involved in issuing the debt in the first place. The erroneous assertion made, without critical reflection, is that the debt somehow “funded” the spending because the spending is “revenue constrained” because the government is the same as a household. Well it is not and it is not and it is not!

Second, the commentator makes the claim that the budget balance will be subject to “adverse interest rate movements” and “pressure from our foreign creditors”. How does that work? The government (and you will know by now that I consolidate the central bank and the treasury operations into this term) sets the short-term interest rate. Further, the coupon (interest) rate on the public debt is determined when it is issued (whether by tap or auction) and the government can manipulate the auction price if it wanted to by altering the volume of debt being issued. It doesn’t do this but it always can. If at anytime the government wanted to reduce its interest bill (and therefore reduce its income add to the non-government sector) but at the same wanted to keep issuing public debt then it can always cut interest rates which would drive down the yields on any new issues. Simple as that!

But moreoever, there is never a question that paying a $ on public debt interest means a $ cannot be spent on a hospital! The government can always do both if it feels that will help fulfill its public purpose.

Further, the idea that “foreign creditors” (by which I assume he means foreign holders of public debt) can in some way impose difficulties on the government of issue is nonsensical in the extreme. What happens if they stop buying the debt? Answer: they stop buying the debt. Further answer: they do something else with their currency. Futher answer: their currency probably rises in value and they kill their export sector. This might actually improve conditions for their own citizens who get more access to domestic resources (not exported) and might force the government to spend more in the domestic economy to fill the spending gap left by the decline in exports. So all good for the foreign citizens.

But for the government of issue – they don’t need the foreign governments to buy the debt. The government of issue can still spend as it desires. Remember that the Chinese only get hold of $USD if the US Government spends them first! So there is really no issue.

Third, the taxpayer funds bogey person appears – again! Taxpayers do not fund anything. Governments fund spending by spending – again! Whether the Government increases or decreases taxes depends on whether it wants to have less or more spending capacity in the private sector. These decisions have nothing fundamentally to do with the spending decision unless the economy is already at full capacity and the government wants more public goods and less private goods in the overall GDP goods and services mix. Then it might increase net spending and also increase taxes (for example). But never conflate this simultaneity with the notion that the taxe rises are “financing” the spending increases.

Further, as noted above, even within a mainstream framework, public debt is used to “pay for” large infrastructure projects which provide a stream of services to future generations. That is exactly why orthodox economists (including the deficit-doves) say you should use debt to “fund” the projects rather than taxes to better align the “burden of payment with the generations that will enjoy the benefits over many periods. So this idea that “interest payments represent past services” is nonsensical even within the orthodox model.

As an aside, presumably this is the rationale that The Greens use when they say that debt should be used to “fund” capital development projects. It is neo-liberal in conception but exploits this intertemporal distribution of burden idea that is embedded in orthodox theory.

The intertemporal distribution of burden logic also means that notions that scare campaigns such as “our kids will be paying for our sins” argument that is being used at present by the deficit-debt nazis is also nonsensical from a mainstream framework unless the debt was being used to buy everyone an ice-cream today – that is, no endurable benefits.

So even within the orthodox paradigm these notions are ridiculous.

But of-course the fundamental conception is misconceived – that is, at the level of first principles. The public debt issue did not fund any spending even though government spending should, in part, be used to develop public infrastructure which delivers long-term benefits to current and future generations. Just take a drive down the Great Ocean Road – built in the 1930s as a public works job creation project! Taxes do not fund any spending so rising interest servicing obligations on government have no necessaryt implications for taxation in the future. Taxes might rise in the future – they might fall – they might stay unchanged. But whatever the outcome there is no intrinsic relationship with the evolution of the deficit.

Conclusion: Reischauer doesn’t get it at all.

Hint: – we will not be tying the concept of fiscal sustainability to any accounting entity such as a debt/GDP ratio.

This blog will be continued in Fiscal Sustainability 101 – Part 2b

Bill Mitchell