Fiscal Sustainability 101 – Part 3d

Understanding why governments issue debt

The fundamental principles that arise in a fiat monetary system are as follows.

  • The central bank sets the short-term interest rate based on its policy aspirations.
  • Government spending is independent of borrowing which the latter best thought of as coming after spending.
  • Government spending provides the net financial assets (bank reserves) which ultimately represent the funds used by the non-government agents to purchase the debt.
  • Budget deficits put downward pressure on interest rates contrary to the myths that appear in macroeconomic textbooks about ‘crowding out’.
  • The ‘penalty for not borrowing’ is that the interest rate will fall to the bottom of the ‘corridor’ prevailing in the country which may be zero if the central bank does not offer a return on reserves, For example Japan easily maintains a zero interest rate policy with record budget deficits simply by spending more than it borrows.
  • Government debt-issuance is a ‘monetary policy’ consideration rather than being intrinsic to ‘fiscal policy’, although in a modern monetary paradigm the distinctions between monetary and fiscal policy as traditionally defined are moot.

Accordingly, debt is issued as an interest-maintenance strategy by the central bank. It has no correspondence with any need to fund government spending. Debt might also be issued if the government wants the private sector to have less purchasing power.

Further, the idea that governments would simply get the central bank to “monetise” treasury debt (which is seen orthodox economists as the alternative “financing” method for government spending) is highly misleading. So debt monetisation is usually referred to as a process whereby the central bank buys government bonds directly from the treasury. In other words, the federal government borrows money from the central bank rather than the public. Debt monetisation is the process usually implied when a government is said to be printing money. Debt monetisation, all else equal, is said to increase the money supply and can lead to severe inflation.

However, fear of debt monetisation is unfounded, not only because the government doesn’t need money in order to spend but also because the central bank does not have the option to monetise any of the outstanding federal debt or newly issued federal debt.

As long as the central bank has a mandate to maintain a target short-term interest rate, the size of its purchases and sales of government debt are not discretionary. Once the central bank sets a short-term interest rate target, its portfolio of government securities changes only because of the transactions that are required to support the target interest rate. The central bank’s lack of control over the quantity of reserves underscores the impossibility of debt monetisation. The central bank is unable to monetise the federal debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to the support rate. If the central bank purchased securities directly from the treasury and the treasury then spent the money, its expenditures would be excess reserves in the banking system. The central bank would be forced to sell an equal amount of securities to support the target interest rate. The central bank would act only as an intermediary. The central bank would be buying securities from the treasury and selling them to the public. No monetisation would occur.

Further, the concept of debt monetisation is inapplicable. However, the central bank may agree to pay the short-term interest rate to banks who hold excess overnight reserves. This would eliminate the need by the commercial banks to access the interbank market to get rid of any excess reserves and would allow the central bank to maintain its target interest rate without issuing debt.

Accordingly, the concept of fiscal sustainability should never make any financing link between debt issuance and net government spending. There is no inevitability for debt to rise as deficits rise. Voluntary decisions by the government to make such a link have no basis in the fundamentals of the fiat monetary system.

Setting budget targets

Any financial target for budget deficits or the public debt to GDP ratio can never be a sensible for all the reasons outlined above. It is highly unlikely that a government could actually hit some previously determined target if it wasn’t consistent with the public purpose aims to create full capacity utilisation. As long as there is deficiencies in aggregate demand (a positive spending gap) output and income adjustments will be downwards and budget balances and GDP will be in flux.

The aim of fiscal policy should always be to fulfill public purpose and the resulting public debt/GDP ratio will just reflect the accounting flows that are required to achieve this basic aspiration.

Accordingly, the concept of fiscal sustainability cannot be sensibly tied to any accounting entity such as a debt/GDP ratio.

Foreign exposure

First, we have learned that exports are a cost and imports provide benefits. This is not the way that mainstream economists think but reflect the fact that if you give something away that you could use yourself (export) that is a cost and if you are get something that you do not previously have (import) that is a benefit. The reason why a country can run a trade deficit – more imports than exports – is because the foreigners (who sell us imports) want to accumulate financial assets in $AUD relative to our desire to accumulate their currencies as financial assets.

This necessitates that they send more real goods and services to us than they expect us to send to them. For as long as that lasts this real imbalance provides us with net benefits. If the foreigners change their desires to hold financial assets in $AUD then the trade flows will reflect that and our terms of trade (real) will change accordingly. It is possible that foreigners will desire to accumulate no financial assets in $AUD which would mean we would have to export as much as we import.

When foreigners demand less $AUD, its value declines. Prices rise to some extent in the domestic economy but our exports become more competitive. This process has historically had limits in which the fluctuations vary. At worst, it will mean small price rises for imported goods. If we think that depreciation will be one consequence of achieving full employment via net government spending then we are actually saying that we value having access to cheaper foreign travel or luxury cars more than we value having all people in work. It means that we want the unemployed to “pay” for our cheaper holidays and imported cars.

We might want to have those values embedded in public policy but I don’t think the concept of fiscal sustainability should reflect these perverse ethical standards.

Further, foreigners do not fund the spending of a sovereign government. If the Chinese do not want to buy US Government bonds then they will not. The US government will still go on spending and the Chinese will have less $USD assets. No loss to the US.

Accordingly, the concept of fiscal sustainability does not include any notion of foreign “financing” limits or foreign worries about a sovereign government’s solvency.

Understanding what a cost is

The deficit-debt debate continually reflects a misunderstanding as to what constitutes an economic cost. The numbers that appear in budget statements are not costs! The government spends by putting numbers into accounts in the banking system.

The real cost of any program is the extra real resources that the program requires for implementation. So the real cost of a Job Guarantee is the extra consumption that the formerly unemployed workers can entertain and the extra capital etc that is required to provide equipment for the workers to use in their productive pursuits. In general, when there is persistent and high unemployment there is an abundance of real resources available which are currently unutilised or under-utilised. So in some sense, the opportunity cost of many government programs when the economy is weak is zero.

But in general, government programs have to be appraised by how they use real resources rather than in terms of the nominal $-values involved.

Accordingly, the concept of fiscal sustainability should be related to the utilisation rates of real resources, which takes us back to the initial point about the pursuit of public purpose.

Fiscal sustainability will never be associated with underutilised labour resources.

Conclusion

This blog aimed to bring together the last two Parts of the discussion. There is a lot of repetition across the mini-series and across all my blogs in general. You cannot say these things enough. Once government policy reflects an understanding of the things that I write about I will turn my blog into a daily surf report! I don’t plan on doing that anytime soon.

But in defining a working conceptualisation of fiscal sustainability I have avoided … as you can see … very much analysis of debt, intergenerational tax burdens and other debt-hysteria concepts used by the deficit nazis. They are largely irrelevant concepts and divert our attention from the essential nature of fiscal policy practice which is to pursue public purpose and the first place to start is to achieve and sustain full employment.

Bill Mitchell

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