Fiscal Sustainability 101 – Part 3b

Understanding the monetary environment

Any notion of fiscal sustainability has to be related to intrinsic nature of the monetary system that the government is operating within. It makes no sense to comment on the behaviour of a government in a fiat monetary system using the logic that applies to a government in a gold standard where the currency was convertible to another commodity of intrinsic value and exchange rates were fixed.

The constraints that the latter monetary system imposed on the national government – necessity of financing spending – tying monetary policy to defending the exchange parity – do not apply to a national government in a fiat monetary system. This is not my opinion or interpretation. It is just a reflection of the fundamental differences between the two monetary systems.

The gold standard is gone. Most countries operate in fiat monetary systems. We should never forget that and reject commentary logic that distorts or denies that intrinsic fact.

We should then understand that a government operating in a fiat monetary system, may adopt, for whatever warped reasons, voluntary restraints that allow it to replicate the operations of a government during a gold standard.

These constraints may include issuing public debt $-for-$ everytime they spend beyond taxation. They may include setting particular ceilings relating to deficit size; limiting the real growth in government spending over some finite time period; constructing policy to target a fixed or unchanging share of taxation in GDP; placing a ceiling on how much public debt can be outstanding; targetting some particular public debt to GDP ratio.

All these restraints are gold standard type concepts and applied to governments who were revenue-constrained. They have no intrinsic applicability to a sovereign government operating in a fiat monetary system. So while it doesn’t make any sense to me for a government to put itself in a strait-jacket which typically amounts to it failing to achieve high employment levels, the fact remains that a government can do it.

But do not be deceived – these are voluntary restraints. They are voluntary applications of constraints applicable to the monetary system that we abandoned long ago to the current monetary system where they have no applicability.

In general, the imposition of these restraints reflect ideological imperatives which typically reflect a disdain for public endeavour and a desire to maintain high unemployment to reduce the capacity of workers to enjoy their fair share of national production (income).

Accordingly, the concept of fiscal sustainability does not include any recognition of the legitimacy of these voluntary restraints. These constraints have no application to a fiscally sustainable outcome. They essentially deny the responsibilities of a national government to ensure public purpose, as discussed above, is achieved.

Understanding what a sovereign government is

A national government in a fiat monetary system has specific capacities relating to the conduct of the sovereign currency. It is the only body that can issue this currency. It is a monopoly issuer, which means that the government can never be revenue-constrained in a technical sense (voluntary constraints ignored). This means exactly this – it can spend whenever it wants to and has no imperative to seeks funds to facilitate the spending.

This is in sharp contradistinction with a household (generalising to any non-government entity) which uses the currency of issue. Households have to fund every dollar they spend either by earning income, running down saving, and/or borrowing. Clearly, a household cannot spend more than its revenue indefinitely because it would imply total asset liquidation then continuously increasing debt. A household cannot sustain permanently increasing debt. So the budget choices facing a household are limited and prevent permament deficits.

These household dynamics and constraints can never apply intrinsically to a sovereign government in a fiat monetary system.

A sovereign government does not need to save to spend – in fact, the concept of the currency issuer saving in the currency that it issues is nonsensical. A sovereign government does not need to borrow to spend. A sovereign government can sustain deficits indefinitely without destabilising itself or the economy and without establishing conditions which will ultimately undermine the aspiration to achieve public purpose.

Further, the sovereign government is the sole source of net financial assets (created by deficit spending) for the non-government sector. All transactions between agents in the non-government sector net to zero. For every asset created in the non-government sector there is a corresponding liability created $-for-$. No net wealth can be created. It is only through transactions between the government and the non-government sector create (destroy) net financial assets in the non-government sector.

This is an accounting reality that means that if the non-government sector wants to net save in the currency of issue then the government has to be in deficit $-for-$. The accumulated wealth in the currency of issue is also the accounting record of the accumulated deficits $-for-$.

So when the government runs a surplus, the non-government sector has to be in deficit. There are distributional possibilities between the foreign and domestic components of the non-government sector but overall that sector’s outcome is the mirror image of the government balance.

To say that the government sector should be in surplus is to also aspire for the non-government sector to be in deficit. In a nation such as Australia, where the foreign sector is typically in deficit (foreigners supplying their savings to us), the accounting relations mean that a government surplus will always be reflected in a private domestic deficit. This cannot be a viable growth strategy because the private sector (which faces a financing contraint) cannot be in deficits on an on-going basis. Ultimately, the fiscal drag will force the economy into recession (as private sector agents restructure their balance sheets by saving again) and the budget will move via automatic stabilisers into defict.

The relationships between a sovereign government and the non-government sector cannot be defied. Private debt build up can allow the government to run surpluses for some time (when the balance of payments is in deficit) but not for very long.

Sub-national governments who use the currency of issue are akin to a household in that they face financing constraints. The only (and major) differences between a household and a sub-national government is that the latter typically has the power to tax (or levy fines) and can thus access cheaper funds in the debt markets as a consequence. While a sub-national government does have some risk of insolvency the reality is that it is extremely low and close to zero.

Accordingly, the concept of fiscal sustainability involves a conceptualisation of a government which is free of financial constraints and has a range of possibilities that are not available to any non-government entity. It would never invoke a notion of public solvency. A sovereign government is always solvent (unless it chooses for political reasons not to be!)

Further, given the non-government sector will typically net save in the currency of issue, a sovereign government has to run deficits more or less on a continuous basis. The size of those deficts will relate back to the pursuit of public purpose.

This blog will be continued in Fiscal Sustainability 101 – Part 3c

Bill Mitchell