On Monday I read an article by Ross Gittins where he expresses his concerns that with the federal election only a year away; wreckless spending promises, and waning taxation revenues will compromise our “budget discipline”. Yesterday I read an article by Peter Hartcher where he also stresses over the budget, this time for the US, saying “both spending cuts and tax increases are inevitable in any realistic scenario”. I know politicians everywhere have been spouting this stuff out the wazoo, but when did it become the conventional wisdom that the government, like a household or an individual, needs to balance its budget?? I respect both journalists, but I tire of both who in their endeavour to appear “balanced” or “centrist” end up conflating the economics of government and that of the individual.
We’ve heard from politicians about the need to be fiscally conservative, the need to exercise budget discipline. So when Mr Gittins and Mr Hartcher echo this what they are suggesting is that the Government needs to run a balanced budget over the long term, just as any fiscally responsible household, or individual would. And it is taken as given why this should be a good thing. To most people the answer would appear obvious. “If I spend too long in debt without an ability to pay that debt off I’ll go bankrupt” so the argument goes, “the same way I’ve got to be fiscally responsible with my budget to avoid going bankrupt, the government must do the same”. I assume this is the logic that the government needing to balance the budget is based on. Except the use of the word logic to describe this deduction is a complete misnomer. Why?
The Government Is Not Like You and Me
The government is unlike a household, or even a business. In Australia we run a fiat currency system, meaning by definition the Australian government is the monopoly issuer of the currency, or the legal tender, in the country. That legal tender is of course Australian dollars. A household cannot print Australian dollars, but the Australian government most certainly can, and does. It is for this reason that I find all this discussion on the government’s need to exercise fiscal discipline completely farcical. Though in reality the Australian government does not print money, it net credits bank accounts. It is the same process in the United States. As Professor Randall Wray from the University of Missouri-Kansas City puts it, they use “keystrokes”.
So it necessarily follows that if the governments debt is denominated in a currency that it is the sole issuer of, then it can’t default on its debts. That is the Australian government cannot go bankrupt. It faces no solvency constraint. It can service those debts by simply using keystrokes, net crediting bank accounts at a touch of a key.
European nations using the Euro however are different. Mr Gittins recognises this but still misses the point when he says “the euro wouldn’t be in trouble were it not for decades of fiscal (budgetary) indiscipline of so many nations”. No, these nations are in trouble because they adopted a foreign currency, the euro, meaning they are unable to service their debts with keystrokes. Their debt is denominated in a currency they do not have sovereign control over. They do not issue the currency they use. Greece needs to get a hold of euros to service its debt – it can do that only by taxing its people or borrowing euros from elsewhere. It cannot use keystrokes. That is why countries with a fiat system issuing their own currency like Japan (the Yen) can run up a national debt of $13.64 trillion (230% of GDP) and still enjoy a robust economy, low unemployment, and a high standard of living. The ongoing economic malaise in nations of the Eurozone is specifically related to their lack of sovereign control of the currency they use.
So if we acknowledge that the Australian government faces no solvency constraint, then why fear budget deficits? I suppose then the argument may turn to inflation, although Mr Gittins doesn’t actually say this in the article. This is generally the case with people who spread fear regarding government spending, they tend to take for granted that everyone knows the government must balance the budget and so offer no explanation as to why. Anyways…onto inflation.
The argument goes that if you create too much money, you have more money chasing the same amount of goods. Necessarily the prices of those goods rise, meaning wages demanded also rise as people see the money they hold worth less and less everyday. This can turn into the doomsday hyperinflation scenario where the magnified effect of rising wages and prices means that inflation always rises faster than money creation can actually catch up. And so creating too much money, or more correctly, running too large a budget deficit (remember money doesn’t actually get printed, rather bank accounts get credited) will bring with it a high inflation danger. This is how the story goes.
This is based on the premise that money is “neutral”. That money has no “real” effect on the economy. That is the idea behind, “more money chasing the same amount of goods”. However this couldn’t be further from the truth. Money absolutely has real effects, and by real effects, we mean creating new jobs, goods, and services in the process. Think about an entrepreneur who has a new idea. It may be an ingenious idea to build a tablet computer in a world where everyone only uses laptops. But he has no money. The entrepreneur goes to the bank for a loan, only after he receives that loan of money can he then go out and lease a warehouse, buy materials, employ staff, pay for advertising, etc etc. This is a micro level case of an injection of money having “real” effects. That injection of money does not mean it simply chases the same amount of goods. Because we live in a dynamic system (time matters, things are not static), that injection of money leads to the immediate creation of employment and the future creation of new goods. Ann Pettifor, a fellow of the New Economics Foundation in London, puts it much more eloquently. She describes “credit creates economic activity, which creates investment, which creates savings”. You cannot have savings without money being spent in the first place. And where does this money, or credit, come from? Out of thin air – keystrokes. So inflation cannot be merely a monetary phenomenon. That is it doesn’t occur simply because there is too much money in the system. There’s more going on there.
The funny thing is Mr Gittins actually knows this. We know he knows this because in another article he wrote a couple of days ago (“The Money Chain Rests On Trust”) he writes “the financial sector [the money chain] is the oil that keeps the economy ticking over”. What he means by this is that if you don’t have new money entering the system, the system stagnates, firms stop employing workers, people stop spending, etc. Money has ‘real’ effects on the economy.
This is not to say that inflation is not a problem that needs to be considered. But that it is not a monetary phenomenon – i.e. high/hyper-inflation does not occur because of too much government spending but rather because of structural issues in the economy. We can see this when we consider everyone’s two favourite examples of hyperinflation, Zimbabwe and the Weimar Republic. Both were cases where the country’s productive capacity was shot. I.e. Both countries were war torn, industry had been decimated; in the case of Weimar there were massive reparations to be paid in terms of gold (not a currency it could issue without constraint), in the case of Zimbabwe there was an unprecedented fall in food supply as the country underwent land reforms. For more detailed analysis read Professor Bill Mitchell from the University of Newcastle and Professor Randall Wray’s musings on the subject:
It should be obvious, Australia, with a healthy, able, and educated population, good infrastructure, sound institutions, is in no danger of hyperinflation. So again, why a fear of government deficits and public debt?
Mr Gittins worries the government has “given no indication how it will pay for…increased spending on a disability insurance scheme, grants for schools and much else”. The conventional wisdom says that taxes need to be raised to pay for this, yet we’ve just debunked this above. The government does not spend with taxes collected, but rather simply using keystrokes. It net credits bank accounts, and money is created. So why do we have taxes, what role do they play?
So Why Tax?
Just as government spending adds money to the system, government taxation drains money from the system. Why would government need to drain money from the system? If it is overheating – in the sense that if there is too much demand and not enough supply in certain areas. So this is the way in which fiscal policy regulates inflation and keeps it in check. But this is not the Australian, or even the global environment of today. Is there really not enough supply? Are we at risk of high inflation?
Last I checked, there are 1.2 million unemployed Australians looking for work, and a further 900,000 underemployed Australians looking for more work. (Taken from Roy Morgan Data, http://www.roymorgan.com/news/polls/unemployment.cfm). That does not suggest a supply shortage of people willing to work. Now let’s turn to retailers. According to macrobusiness (http://www.macrobusiness.com.au/2012/10/retail-sales-in-detail/) retail sales are “well down relative to the prior decades growth rates”. No supply shortage there, in fact retailers are all whining about how people aren’t spending enough, there is not enough demand. Even the housing supply shortage is a myth. The National Housing Supply Commission reported a shortfall of 85000 dwellings. Phillip Soos uses Census data to break down in the following article (http://theconversation.edu.au/beware-the-rent-seeking-organisation-dont-be-dudded-by-housing-data-8112) how the NHSC reached this number by fudging the figures and including the homeless and those in need of social housing. I suggest you read the article. Even this is a case, not of not enough supply, but rather not enough demand – it explains part of the downturn in the construction sector.
The overwhelming trend in the developed world at the moment, and certainly in Australia, is one of deflation, pent up supply, and not enough demand. One need only look at the actions of the RBA (and Central Banks around the world) in cutting interest rates. So why are we continually hearing about the need for the government to balance the budget, and worrying about spending programs? I’ve continually stressed that the government faces no solvency constraint. It certainly does not face an inflation constraint in the current climate. I’d like to offer one more argument.
If you view the economy as a whole and look at financial flows, or where all the money in the system is travelling to and from, it is possible to divide it into three sectors. The government (public) sector, the private sector (households and businesses), and the external sector (the trade balance with the rest of the world). What this means is that the sectoral balance (the net amount of money being accumulated) of the private sector and external sector must equal the sectoral balance of the government sector. So if the private sector is running a surplus, and the external sector (or rest of the world) is running a surplus against Australia, then the government sector must be running a deficit equal to the two. This is an identity, it is true by definition, it describes how our system works. And Mr Hartcher, this is the same system at work in the United States.
Below is a chart put together by Professor Scott Fullwiller from Wartburg College showing sectoral balances for the US over the last 60 years.
You’ll notice the sectoral balances are expressed as a percentage of GDP. The External Balance is called the “Capital Account”. And that the government has traditionally run a deficit, and the private sector generally ran a surplus as a result. You’ll see during the Clinton years when the private sector went into deficit (a period when they started accumulating huge amounts of debt) the government sector started running budget surpluses.
In Australia today, the private sector is accumulating dollars; households and businesses are net saving. The sectoral balance of the private sector is in surplus. In the external sector, we have a current account deficit (a capital account surplus), we import more than we export, so the external balance is negative (the rest of the world is running a surplus against Australia). This means that by definition that the government sector is in deficit. The government is net spending. If the government was net saving and the external balance was still in deficit then the private sector would have to be net spending, or accumulating more debt. Let me reiterate – if the external sector is in deficit, households and government cannot both save!
This is quite a profound result – I wonder if Mr Gittins knows this. That if Australia is running a current account deficit (the external balance is negative) as it has done historically, then the private sector and the government sector cannot both run a surplus. One must be in deficit for the other to be in surplus. One must be spending for the other to be saving. So every time a politician or political commentator, or your neighbour says the government should return the budget to surplus, they are also saying that households and businesses should take on more debt. Private debt is roughly 160% of GDP, while public debt is only 6% of GDP. Households service debt using income earnt, and the government services debt using keystrokes. Where does that leave us? We don’t have a problem of public debt. We have a problem of private debt.
Quite a lot to digest for the first post… So it follows that government deficits can and should be used to pay for a National Disability Insurance Scheme, and for a Gonski Model of School Funding, or any other initiative that invests in our nation and its people. The government doesn’t need to give “indication of how it will pay for this”, because it should be obvious that governments that issue their own currency spending using keystrokes. It doesn’t actually need to borrow the money from anywhere, or tax it from anywhere, it simply wills it into existence. The government doesn’t need to be concerned about inflation because we are currently in a deflationary environment. Moreover that money that it spends on things like NDIS and School Funding, actually increases the nations productive capacity, it increases our human capital, it may actually mean we’re able to produce new things, create new industries and new jobs. If running the country was as simple as balancing the books, mums and dads everywhere could do it (no diss to mums and dads everywhere). What we create, we can afford. Stop reducing the national debate to an accounting exercise, and let’s start talking about the kind of world our generation can create. Mr Gittins and Mr Hartcher, it’s time to read up and start holding pollies accountable for what they say we can’t afford.