Fiscal Sustainability 101 – Part 2b

Another contributor to the National Journal debate was James K. Galbraith, Professor of Economics, University of Texas, who works with us within the modern monetary theory camp. So you will expect he will say something quite different to the commentators I have covered from the debate to date (in Fiscal sustainability 101 – Part 1 and above).

Galbraith begins by saying that:

Chairman Bernanke may, if he likes, try to define “fiscal sustainability” as a stable ratio of public debt to GDP. But this is, of course, nonsense. It is Ben Bernanke as Humpty-Dumpty, straight from Lewis Carroll, announcing that words mean whatever he chooses them to mean …. A stable ratio of federal debt to GDP may or may not be the right policy objective. But it is neither more nor less “sustainable,” under different economic conditions, than a rising or a falling ratio.

Galbraith correctly points out that at various times during the course of US history, the debt/gdp ratio been risen and fallen with the fortunes of the economy – not driving the fortunes but reflecting them. So during World War II it soared and then fell back as peace arrived and growth ensued.

His point is the valid one – the ratio wanders around “all over the shop” and the real question if whether it is “appropriate to the underlying economic conditions”. So you can see that it is the underlying economic conditions that should be the focus of fiscal policy settings not the accounting data (for example, debt/GDP ratios) that “record” what the government has been doing to fulfill its public purpose charter.

Galbraith then tells us that:

History has a second lesson. In a crisis, the ratio of public debt to GDP must rise. Why? Because a crisis … is a national emergency, and national emergencies demand government action. That was true of the Great Depression, true of war, and true of the Great Crisis we’re now in. Moreover, we’ve designed the system to do much of this work automatically. As income falls and unemployment rises, we have an automatic system of progressive taxation and relief, which generates large budget deficits and rising deficits. Hooray! This is precisely what puts dollars in the pockets of households and private businesses, and stabilizes the economy. Then, when the private economy recovers, the same mechanisms go to work in the opposite direction.

After concluding that the rising “ratio of debt to GDP” currently, just represents a “strong fiscal response to the crisis” which was required and is to be applauded, Galbraith says that:

It is therefore a big mistake to argue that the next thing the administration and Congress should do, is focus on stabilizing the debt-to-GDP ratio or bringing it back to some “desired” value. Instead, the ratio should go to whatever value is consistent with a policy of economic recovery and a return to high employment. The primary test of the policy is not what happens to the debt ratio, but what happens to the economy.

Galbraith also reflects on the previous commentator’s claims that “a very high public-debt-to-GDP ratio leaves the US vulnerable to pressure from foreign creditors” (aka the Chinese)! I covered this point above. Galbraith offers this perspective. This argument:

… displays a very vague view of monetary operations and the determination of interest rates. The reality is in front of our noses: Ben Bernanke sets whatever short term interest rate he likes. And Treasury can and does issue whatever short-term securities it likes at a rate pretty close to Bernanke’s fed funds rate. If the Treasury doesn’t like the long term rate, it doesn’t need to issue long-term securities: it can always fund itself at very close to whatever short rate Ben Bernanke chooses to set … The Chinese can do nothing about this. If they choose not to renew their T-bills as they mature, what does the Federal Reserve do? It debits the securities account, and credits the reserve account! This is like moving funds from a savings account to a checking account. Pretty soon, a Beijing bureaucrat will have to answer why he isn’t earning the tiny bit of extra interest available on the T-bills. End of story.

I could have written that myself although I wouldn’t use the terminology “they could always fund themselves” because it invokes the notion that the government is revenue-constrained. Jamie knows that isn’t true so I would just steer clear from using those invocations – because in the hands of the ignorant they became dangerous attacks on the operations of fiscal policy!


In Part 3, I will provide a brief summary of what all this means for a meaningful and productive conceptualisation of fiscal sustainability. That will come early next week if all goes well.

You will note that I have not said anything about politicial sustainability. I am not a political scientist. But political sustainability is whatever can be deemed acceptable by the people who vote for the polity. But what people think about the economic conduct of the government should not be distorted by mistruths about the essence of the fiat monetary system.

The way the modern monetary system works is neither left wing or right wing. The fundamental operations of the system are what they are. You can then impose whatever ideology you like on those operations although I accept a deeper ideological critique can be made of using fiat money in the first place!

Bill Mitchell


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