Deficit Spending 101 – Part 3

This is Part 3 in Deficits 101, which is a series I am writing to help explain why we should not fear deficits. In this blog we consider the impacts on budget deficits on the banking system to dispel the recurring myths that deficits increase the borrowing requirements of government and that they drive interest rates up. The two arguments are related. The important conclusions are: (a) deficits introduce dynamics which put downward pressure on interest rates; and (b) debt issuance by government does not “finance” its spending. Rather debt is issued to support monetary policy which is expressed as the desire by the RBA to maintain a target interest rate.

In Deficits 101 Part 1 I provided a diagram which depicted the vertical relationship between the government and non-government sectors whereby net financial assets enter and exit the economy. What are these vertical transactions between the government and non-government sectors and what is the importance of them for understanding how the economy works? Here is another related diagram (taken from my latest book Full Employment Abandoned: Shifting sands and policy failures) to help connect the pieces. You might like to click on the picture to get it into a new window and then print it while you read the rest of the text.

Vertical and horizontal monetary relations

You will see that this diagram adds more detail to the original diagram from Part 1 which showed the essential relationship between the government and non-government sectors arranged in a vertical fashion.

Focusing on the vertical train first, you will see that the tax liability lies at the bottom of the vertical, exogenous, component of the currency. The consolidated government sector (the Treasury and RBA) is at the top of the vertical chain because it is the sole issuer of currency. The middle section of the graph is occupied by the private (non-government) sector. It exchanges goods and services for the currency units of the state, pays taxes, and accumulates the residual (which is in an accounting sense the federal deficit spending) in the form of cash in circulation, reserves (bank balances held by the commercial banks at the RBA) or government (Treasury) bonds or securities (deposits; offered by the RBA).

The currency units used for the payment of taxes are consumed (destroyed) in the process of payment. Given the national government can issue paper currency units or accounting information at the RBA at will, tax payments do not provide the state with any additional capacity (reflux) to spend.

The two arms of government (treasury and central bank) have an impact on the stock of accumulated financial assets in the non-government sector and the composition of the assets. The government deficit (treasury operation) determines the cumulative stock of financial assets in the private sector. Central bank decisions then determine the composition of this stock in terms of notes and coins (cash), bank reserves (clearing balances) and government bonds.

The diagram above shows how the cumulative stock is held in what we term the Non-government Tin Shed which stores fiat currency stocks, bank reserves and government bonds. I invented this Tin Shed analogy to disabuse the public of the notion that somewhere down in Canberra was a storage area where the national government was putting all those surpluses away for later use – which was the main claim of the previous federal regime. There is actually no storage because when a surplus is run, the purchasing power is destroyed forever. However, the non-government sector certainly does have a Tin Shed within the banking system and elsewhere.

Any payment flows from the Government sector to the Non-government sector that do not finance the taxation liabilities remain in the Non-government sector as cash, reserves or bonds. So we can understand any storage of financial assets in the Tin Shed as being the reflection of the cumulative budget deficits.

Taxes are at the bottom of the  vertical chain and go to rubbish, which emphasises that they do not finance anything. While taxes reduce balances in private sector bank accounts, the Government doesn’t actually get anything – the reductions are accounted for but go nowhere. Thus the concept of a fiat-issuing Government saving in its own currency is of no relevance. Governments may use its net spending to purchase stored assets (spending the surpluses for instance on gold or as in Australia on private sector financial assets stored as the Future Fund) but that is not the same as saying when governments run surpluses (taxes in excess of spending) the funds are stored and can be spent in the future. This concept is erroneous. Finally, payments for bond sales are also accounted for as a drain on liquidity but then also scrapped.

The private credit markets represent relationships (depicted by horizontal arrows) and house the leveraging of credit activity by commercial banks, business firms, and households (including foreigners), which many economists in the Post Keynesian tradition consider to be endogenous circuits of money. The crucial distinction is that the horizontal transactions do not create net financial assets – all assets created are matched by a liability of equivalent magnitude so all transactions net to zero. The implications of this are dealt with soon when we consider the impacts of net government spending on liquidity and the role of bond issuance.

The other important point is that private leveraging activity, which nets to zero, are not an operative part of the Tin Shed stores of currency, reserves or government bonds. The commercial banks do not need reserves to generate credit, contrary to the popular representation in standard textbooks.

Bill Mitchell

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