Part II of Series on Economics: Everything you need to know about Deficits, Surpluses and Government Spending (12,000 words)

Deficits, Surpluses and Government Spending: What does it all mean? How should governments run themselves?

The key observation of “Modern Monetary Theory”, in its descriptive essence, is that a sovereign currency-issuer (a country which produces its own currency) with a floating exchange rate is not, in fact, directly financially constrained (it is, of course, constrained in several other ways, a subject which will later admit of lengthy discussion (and we must include the caveat, for reasons we’ll explore later, that the currency is desired by other countries)). Why this is so is – to put it in a nutshell – that such a government has no issue of convertibility: it doesn’t have to maintain gold reserves sufficient to back the circulating currency, as everyone did before Nixon’s gold shock and the end of the Bretton-Woods era (the beginning of the ‘fiat money’ era), and it doesn’t have to do the same with some other country’s sovereign currency either (as happens with a ‘fixed exchange rate’, a system which Australia kept until 1983). Such a government therefore can’t default, except on foreign-currency-denominated liabilities (though the major sovereign countries wouldn’t have any such liabilities). These facts mean that whatever other purposes the issuing of bonds may serve for a sovereign currency-issuing government (purposes which I will later discuss), it is simply erroneous to claim that this operation is ‘funding’ spending.

Probably around half of the world’s countries are sovereign currency-issuers. The Eurozone countries are not sovereign currency-issuers (a major cause of the EU’s problems, as I will discuss); Ecuador, East Timor, El Salvador, Marshall Islands, Micronesia, Palau, Turks and Caicos, British Virgin Islands and Zimbabwe all use the US dollar as their official currency; and there a few other miscellaneous examples of countries which are not financially sovereign [https://qz.com/260980/meet-the-countries-that-dont-use-their-own-currency/]. But the rest of the world’s countries use unbacked, inconvertible fiat money. Unfortunately, all of the world’s financially sovereign countries still impose more or less arbitrary operational constraints on the extent to which they can spend, and set budget-balancing goals completely divorced from relevant economic fundamentals. In setting these budget-balancing goals, the politicians and technocrats of these countries universally adopt the fallacious analogy of a sovereign government to a business (‘Just like a small business owner, we need to keep our finances in order!’) and loudly fret the prospect of credit rating downgrades (or, if they are from an opposition party, hammer the sitting party for jeopardising the rating).

Although it is boring, I think it is important to understand the nature and effect of the self-imposed operational constraints because it allows one to understand two things crucial to my thesis in this essay:

1.) How sovereign governments actually run themselves today

2.) How they might run themselves ideally.

Sadly, I have come to realise that in order to explain the nature and effect of these self-imposed operational constraints, I will have to do something much bigger first: explain, in broad outline, how monetary policy works. In particular, I will have to explain how central banks manage interest rates through “open market operations” with private banks, and what would happen if this process was changed. The most crucial thing I will touch on in the process is what the sale of debt actually does, and whether it needs to happen at all. After completing all this will I get onto discussing the substantial, macroeconomic constraints – the discussion which will eventually lead me to a verdict on the debate between the deficit owls and hawks.

Part I: How the Monetary System Currently Works

The key, general self-imposed constraint on spending is central bank independence. As L. Randall Wray points out here [http://neweconomicperspectives.org/2011/12/mmp-blog-28-government-spending-with.html], two very common specific operational constraints for financially sovereign countries across the world are: “A) the treasury keeps a deposit account at the central bank, and must draw upon that in order to spend, and B) the central bank is prohibited from buying bonds directly from the treasury and from lending to the treasury (which would directly increase the treasury’s deposit at the central bank)”. These are both products of central bank independence. The US apparently has both of these self-imposed constraints; Australia, it turns out (from perusing the RBA’s website), has constraint A and only allows the treasury to overdraw on its account at the central bank in special circumstances (http://www.rba.gov.au/monetary-policy/about.html#the_implementation_of_monetary_policy). About other countries, I can’t be bothered to find out the specifics (and nobody makes it obvious (you can’t search “operational constraints on fiscal policy imposed in [Country X]”)). But certainly it’s clear that central bank independence has been the norm in the ‘West’ since the Reagan-Thatcher devolution, so I’m sure the UK and Canada (and so on) have similar constraints.  Anyway, the long and short of these operational constraints is that they impose an extra pain in the bum for the government to spend money (deposit private bank accounts). By imposing multiple layers of separation between the treasury and the central bank, you make it harder to carry out fiscal policy.

The question is: what effect does this separation have? As I established above, answering this involves taking a detour through the exciting world of monetary policy. So that’s what we’ll do now.

In order to even begin to understand how central banks do the main thing they do – namely, set the interest rate – you first need to recognise that private banks hold a chunk of their reserves in (of course purely electronic) accounts at the central bank. In Australia, these are called “exchange settlement accounts”, which helpfully conveys a sense of their purpose: banks need to have accounts at the central bank to settle their direct obligations to each other after the day is done (because of all the non-cash transactions between their respective bank customers) and to borrow from and lend to each other to equalise their reserves to the reserve-requirement level.

Now, everybody knows that central banks set interest rates, but probably only a small slice of the population knows that this process isn’t just a kind of legal dictate which the banks obey when making loans; instead, central banks operate daily with what is called an “overnight interest rate target” for interbank lending. The achievement of this rate target requires the central bank to add or drain private bank reserves (held in their accounts at the central bank) in just the right quantity. Banks decide the interest rates they will set for consumer and business loans based more or less on the interbank lending rates (when the system’s working right at least).

(And, of course, barring a huge build-up of private debt in the economy (as there has been in the countries worst hit by the GFC since 2008, bringing about “secular stagnation” (read: “credit stagnation” or “debt deflation”)), low interest rates typically spur investment (it may, of course, be wildly misdirected investment, like investment in toxic financial instruments, and this kind of investment is encouraged when the real economy is so indebted) while higher interest rates don’t as much.)

The overnight rate (note that this is minus the “target” part) is, of course, the interest rate at which major financial institutions actually borrow and lend one-day funds among themselves (called the “cash rate” in Australia and probably New Zealand). All central banks set an overall target for this rate: it happens monthly in the UK, monthly in Australia, eight times a year in the US and eight times a year in Canada. It’s when these rate-setting meetings occur that we get those familiar news reports, usually ominous in tone and mood (“Today the [insert specific name of central bank here] is set to lower the interest rate, in the face of persistent stagnation”).

Now, in order to hit a non-zero overnight rate, the central bank needs to add or drain reserves to ensure that the banking system has just the amount of reserves desired. Why? Unfortunately, it’s complicated.

The first thing you need to know is what actually happens when the central bank buys from or sells to the private banks. Fortunately, this can be articulated fairly simply (at least when you overlook precise details which aren’t relevant to the accounting). Basically, it works as follows:

When the central bank sells bonds to a private bank, that bank’s reserve account (analogous to a “checking account”) is debited and it is credited with treasury securities (in a kind of higher-paying “savings account”): thus, reserves are depleted. When the central bank buys bonds from a private bank, the reverse happens: reserves are added.

The second thing you need to know is that the amount that the government has spent in a given day over taxes is the determinant of the overall level of bank reserves. At the end of any given day, if the government has spent as much as it has taken out in taxes, the reserve surpluses and reserve deficits of banks will cancel out; if the government has spent more than it has taken out in taxes, then the bank reserves will overall be in surplus; and if the government has taxed more than it has spent, then the bank reserves will overall be in deficit.

With this knowledge transmitted, I can now explain how bank-reserve-alterations help the central bank hit its target rate.

However much money has been spent in a given day, the banks with reserves below the required-rate (“deficit banks”) will be looking for the best deal on loans: they will either look to the other banks for loans, or they may expect the central bank to sell discount window loans/“repos” (a “repurchase agreement” where the government buys one of its own securities on the condition that it will sell it back at a higher price, typically within 1-7 days), to buy back government securities outright, or to purchase gold, foreign currencies or even private sector financial assets. The central bank will only want to do these purchases, however, if the overnight (interbank) lending rate is higher than their own target overnight rate (an overall reserve deficit does make this more likely because it will generally push up the overnight rate (when lenders’ funds are tight, interest rates go up)). By making these purchases, the central bank is getting the overnight rate on target, to the lower level they desire.

As for surplus banks, the story is a bit more complicated again: in many countries – Australia and Canada, for example – and in zones like the EU, the government actually pays interest on surplus reserve accounts: the RBA sets this return at 25 basis points less than the cash rate. By contrast, in the US and Japan before the crisis, this was at 0 (MMTers tend to prefer this zero rate, as we will see). However much money has been spent in a given day, surplus banks will only be willing to reduce their reserves if they can get a better rate of interest by lending to deficit banks than keeping their excess reserves in their respective central bank accounts. If the banking sector is overall in surplus, and the central bank wants to hit a nonzero overnight rate, the central bank will seek to sell “reverse repos”, sell securities outright, and hand off all the other things it has its hands on in order to drain these reserves. If it wants to hit a relatively high interest rate relative to the amount of spending that has gone on in the day, it will need to sell a lot of debt. Because targeting the interest rate involves manipulating the reserve accumulations, the amount of bank reserves is never discretionary when a non-zero interest rate is the target. The interest rate itself is often not really discretionary: the QE policies that were applied across most of the world after the GFC made zero rates pretty much unstoppable by massively overstuffing bank reserves; the treasury can’t make an infinite number of securities after all.

In this paper [http://www.cfeps.org/pubs/wp-pdf/WP48-Wray.pdf], Mr. Wray adds some interesting details to this story:

“While a central bank employs a fairly large staff to estimate and predict reserve supplies and demands, it is actually quite easy to determine whether the banking system faces excess or deficient reserves: the overnight rate will move away from target, triggering a nearly automatic offsetting reserve add or drain by the central bank. Central banks also supervise banks and other financial institutions, engage in lender of last resort activities (a bank in financial difficulty may not be able to borrow reserves in the interbank lending market even if excess reserves exist at the aggregate level), and occasionally adopt credit controls, usually on a temporary basis.”

To finish this section, I will present some irrefutable evidence that bond sales do not ‘fund’ deficits for sovereign currency-issuers: Japan’s “public debt” exceeded one quadrillion yen (10.46 US$10.46 trillion) in 2013, more than twice its annual gross domestic product, after more than 20 years straight of budget deficits (look up the distinction between “public debts” and “deficits” if you don’t already know it). And yet it has not been forced to pay higher bond yields and thereby ‘capitulated’; in fact, bond yields steadily declined from 1991 to 2016 and are still currently very low. The ‘secret’ to this is that the Central Bank of Japan buys back 70% of its own bonds, while much of the rest is purchased by Japanese banks and trust funds, insulating the yields of such bonds from the international bond market and the effects of credit ratings agencies. The credit ratings agencies truly had no effect on Japan (in fact, more or less a reverse effect): on May 31, 2002, Moody’s Investors Service cut Japan’s long-term credit rating way down to A2 – below that given to Botswana, Chile and Hungary – but bond yields didn’t go up at all. As the well-known MMTheorist and blogger Bill Mitchell points out here [http://bilbo.economicoutlook.net/blog/?p=28918], any country could decide to manage the yield of bonds if it wanted to by carrying out the buybacks that Japan has done, and without causing a great increase in inflation (because, as we’ll see, the “quantity theory of money” is completely wrong; it matters how and to whom money is spent (extra bank reserves contribute nothing to inflation, which is why QE hasn’t caused any inflation)); and any country, if it so desired, could stop issuing bonds completely. This latter reform would, however, require the end of central bank independence. It is to this possibility we turn next.

Part II: On Whether We Should End Central Bank Independence and Accept a Permanent Zero Interest Rate

Like several other prominent MMTheorists (Warren Mosler, Randy Wray), Bill Mitchell has made the case that we should end central bank independence, make fiscal policy the only means by which governments manage the economy and accept a permanent  zero interest rate policy. In this blogpost (http://bilbo.economicoutlook.net/blog/?p=31715), he makes the case for the end of debt issuance (which entails the end of central bank independence and the takeover of fiscal policy) and here, he makes the case for a permanent zero interest rate (http://bilbo.economicoutlook.net/blog/?p=4656). I’ll say more about what I think about these radical proposals later, but for now I’ll simply outline his arguments, using quotes from these two blogposts.

First the case for the end of debt issuance.

Mitchell believes that, in order to achieve maximum financial stability: “(a) the key financial institutions must be stable and engender confidence that they can meet their contractual obligations without interruption or external assistance; and (b) the key markets are stable and support transactions at prices that reflect fundamental forces.” He gives a sevenfold list of “essential requirements” of a “stable financial system” (I assume he means “as stable as can be”, not truly “stable”; if he doesn’t mean this, he is not on the same page as Steve Keen (following Hyman Minsky) and me (following Keen)). This list is as follows:

1. Clearly defined property rights;
2. Central bank oversight of the payments system;
3. Capital adequacy standards for financial institutions;
4. Bank depositor protection;
5. An institutional lender-of-last resort when private institutions refuse to lend to solvent borrowers in times of liquidity crisis;
6. An institution to ameliorate coordination failure among private investors/creditors;
7. The provision of exit strategies to insolvent institutions.

He claims that “none of these requirements rely on the existence of a viable government bonds market”.

He puts his call-to-arms to the vested interests who benefit from the ‘free lunch’ in the following sardonic fashion (mocking their pretense to truly love the free market, rather than worship greed and their own self-interest): “The burden of proof falls on those arguing in favour of such issuance to show that the market in question is incapable of viable operation without government intervention and will, unassisted, produce outcomes detrimental to the macro priorities we discussed earlier – full employment etc.”

He rejects the argument that public debt issuance is needed to support “the yield curve” with a crucial use by financial markets as “the benchmark risk free asset, which provides a benchmark for pricing any other debt security”. He points out that there are clear alternatives for pricing debt securities, of which he gives two examples:

“1. The market could price securities against other securities with similar characteristics.

2. Market participants could price securities with respect to the interest rate swap curve.”

He rejects the argument that public debt is needed to provide a long-term investment vehicle. Proponents of this objection argue, he says, that “if superannuation and life companies were unable to purchase government debt then they would struggle to match their long-dated liabilities with appropriate returning assets”, and that “eliminating the government bonds market would deny workers of a risk free, dollar-denominated asset to invest there [sic] savings in”, thereby making retirement planning “highly uncertain”. But while “he is supportive of workers being able to save (risk manage their futures) in a safe way”, he thinks that clearly doesn’t justify “the massive corporate welfare that accompanies the issuance of public debt.” He points out that “government bonds are in fact government annuities”, and thinks it is clearly a bad thing that the private sector has “access to government annuities rather than […] directing real investment via [eg] privately-issued corporate debt”. He notes that by “facilitating portfolio diversification”, government bonds help private profit-seeking investors. This, he claims, “interferes with the investment function of markets” and contradicts the notion that direct government payments should “be limited to the support of private sector agents when failures in private markets jeopardise real sector output (employment) and price stability.”

He then points out that there are clear alternatives. The claim that bond issues are essential for long-term investments for workers’ retirement schemes “requires a comparison of this method of retirement subsidy against more direct methods involving more generous public health and welfare provision and pension support” – and yet this is not given. He himself believes that “there is a much more effective way to provide a risk-free savings vehicle for workers”, as follows:

“The government could create a National Savings Fund, fully guaranteed by the currency-issuing capacity of the government, which could provide competitive returns on savings lodged with the fund. There would be no public debt issuance (and the associated corporate welfare and government debt management machinery) required.”

He rejects the argument that government debt is needed to provide a ‘safe haven’ for investors in times of financial instability or strife. He observes that “The ‘flight to quality’ argument suggests that it is beneficial to the macro economy for investors to have a risk free domestic asset available to avoid capital losses on other assets.” But, in addition to his objections, outlined above, to subsidy through government annuities, he also notes that “government bonds compete directly with these other assets, thereby driving down their prices and exacerbating matters during ‘flights to quality’.” In a monetary economy, he claims, “investors can always hold money balances by increasing actual cash holdings or banking system deposits”. Furthermore, if we imagine a system which possesses characteristics 4.) and 5.) of his “stable financial system”, so that people have effective “deposit insurance”, then “bank deposits would be equivalent to holding government bonds anyway for all practical purposes.” He points out that “this also passes the ‘risk’ to private banks when they select their assets”. Overall, he doesn’t believe there is any “compelling real macroeconomic reason why risk and return decisions by private maximising agents should be ‘further protected’ by retreat to a market distorting government annuity.”

The final argument he rejects is one that we’ll be familiar with: that debt issuance is needed for implementing monetary policy. Now, as I’ve already made clear, Mitchell ultimately advocates the total abandonment of monetary policy and the permission of the interest rate to settle at a permanent zero level (and we’ll get to his argument for that in a few paragraphs’ time), but he also holds that, even if you want a non-zero interest rate, that can be achieved without debt issuance, “through the use of the support rate on excess reserves”. The way this would work, I think, is this:

If the level of spending over taxation is not super high (so that at least some banks have deficit reserves), and if surplus banks have a support rate and if the central bank is no longer offering debt to the deficit banks, then the surplus banks will set a rate higher than the support rate for loans to the deficit banks (because they want the best deal) and the deficit banks will accept it (because there is no alternative). The higher the support rate is set the higher will be the overnight rate. If, on the other hand, there are no deficit banks, then the support rate will simply determine the interest rate.

Mitchell also has a significant positive argument for abandoning debt issue: that ending it, and all that goes along with it, will retrieve a lot of resources that could be put to far more productive use.  As he puts it:

“The opportunity costs in terms of the labour employed directly and indirectly in the public debt ‘industry’ are both real and large. The ‘cottage industry firms’ that characterise the public debt industry use resources for public debt issuance, trading, financial engineering, sales, management, systems technology, accounting, legal, and other related support functions. These activities engage some of the brightest graduates from our educational system and the high salaries on offer lure them away from other areas such as scientific and social research, medicine, and engineering. It could be argued that the national benefit would be better served if this labour was involved in these alternative activities. Government support of what are essentially distributional (wealth shuffling [sic]) activities allows the public debt market to offer attractive salaries and distorts the allocation system.

While this labour may move within the finance sector if public debt issuance terminated, the Government [sic] could generate attractive opportunities by restoring its commitment to adequate funding levels for research in our educational institutions.

On balance, public debt markets appear to serve minor functions at best and the interest rate support can be achieved simply via the central bank maintaining current support rate policy without negative financial consequences. The public debt markets add less value to national prosperity than their opportunity costs. A proper cost-benefit analysis would conclude that the market should be terminated.”

Now onto his case for a permanent zero interest rate.

Mitchell begins his case for a permanent zero interest rate in the blogpost I linked before by mounting a case against the neoclassical-economics construction of the “neutral rate of interest” (sometimes called the “equilibrium interest rate”) – the default intellectual weapon that an opponent would invoke if someone were to bring up the idea of establishing a permanent interest-rate level. The idea of a neutral interest rate is, in fact, very important to our discussions because it underpins three beliefs of mainstream economists used to justify central bank independence: “the belief in the primacy of monetary policy as the preferred counter-stabilisation tool”; the belief “that the central bank can maximise real economic growth by achieving price stability”; and the belief “that when the central bank target interest rate is below the “neutral rate of interest”, inflation will break out (eventually) and vice versa [with deflation].”

The best known exposition of the idea of the neutral interest rate can apparently be found in the 1898 book by Swedish monetary theorist Knut Wicksell (1851-1926). Mitchell claims that “Wicksellian thinking is very influential among central bankers.”

In his classic book Interest and Prices, Wicksell apparently defined a “natural interest rate” as follows:

“There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tend neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital (emphasis in original).” [1936 edition: 102].

Mitchell explains: “Consistent with the view held in those times that the loanable funds market brought savers together with investors, the natural rate of interest is that rate where the real demand for investment funds equals the real supply of savings.”

Mitchell describes how Wicksell differentiated “the interest rate in financial markets which is determined by the demand and supply of money and the interest rate that would mediate “real intertemporal transfers” in a world without money”, and stipulated that the “natural interest rate” reflects only “real (not nominal) factors”. Wicksell thus agreed with the (completely false) classical idea that money is a “veil over the economy”, only affecting the price level. In the book referenced earlier, he writes:

“Now if money is loaned at this same rate of interest, it serves as nothing more than a cloak to cover a procedure which, from the purely formal point of view, could have been carried on equally well without it. The conditions of economic equilibrium are fulfilled in precisely the same manner.”

Money affects the precise level in Wicksellian thought in the following way:

“The deviation between the interest rate determined in the financial markets and the natural rate impacts on the price level. So when the money interest rate is below the natural rate, investment exceeds saving and aggregate demand exceeds aggregate supply. Bank loans create new money to finance the investment gap and inflation results (and vice versa, for money interest rates above the natural rate).”

Mitchell describes exactly how this leads to policy conclusions:

“With the natural rate of interest an unobservable imaginative construct, Wicksell claimed that the link between price level movements and the gap between the two interest rates provided the clue for policy makers.

He wrote (p.189) that:

“This does not mean that the banks ought actually to ascertain the natural rate before fixing their own rates of interest. That would, of course, be impracticable, and would also be quite unnecessary. For the current level of commodity prices provides a reliable test of the agreement of diversion of the two rates. The procedure should rather be simply as follows: So long as prices remain unaltered the banks’ rate of interest is to remain unaltered. If prices rise, the rate of interest is to be raised; and if prices fall, the rate of interest is to be lowered; and the rate of interest is henceforth to be maintained at its new level until a further movement of prices calls for a further change in one direction or the other.(emphasis in original).””

The key point about this, as Mitchell notes, is that “to advocate Wicksell’s theory you have to buy into the whole theoretical box-and-dice – in all its inanity and inconsistency.” You have to believe that “markets equilibrate through price adjustments and the economy tends to full employment (meaning there cannot be a deficiency of aggregate demand). So if consumption falls (because saving rises), the interest rate (in the loanable funds market) falls (excess supply of loans) and investment rises to fill the gap left by the fall in consumption. This is Say’s Law which is restated as Walras’ Law when multiple markets are introduced.”

This ultimately leads to the following absurd claims:

“The interest rate adjusts to the natural interest rate where the full-employment level of savings equals investment and all is well. There is never a shortage of investment projects but their introduction is impacted upon by the cost of funds. There is never [involuntary] unemployment!”

I will now quote from my 67-Page Dismantling of Mainstream Economics [http://writingsoftclaitken.blogspot.com.au/2016/02/a-67-page-dismantling-of-economics-of.html] where I quoted from Keen to explain what Say’s Law is, and why it is false:

“[The pre-Great Depression classical economists] believed that individual markets might be out of equilibrium at any one time, but the overall economy, the sum of all those individual markets, was bound to be balanced. As Keen explains, “The basis for this confidence was the widespread belief, among economists, in what Keynes termed Say’s Law.” This Law essentially stated that ‘supply creates its own demand’. More precisely, it is defined by Steve Kates (the strongest modern-day proponent of the Law), as the proposition that “the sale of goods and services to the market is the source of the income from which purchases are financed”. (What this actually means, in practical terms, is that slumps can never be caused by an overall deficiency in demand, but are always due to sectoral imbalances.)

Amidst the devastation and misery of the Great Depression, Keynes challenged this principle. Keynes’ critique of Say’s Law was what he himself described as “the essence of the General Theory of Employment”. […]

Keen gives a simplified version which is easy enough to understand:

“Keynes divided all output into two classes: consumption and investment. If the economy was in equilibrium, then Say’s Law would argue that excess demand for consumption goods would be zero, and likewise for investment goods.

Keynes then imagined what would happen if demand for consumption goods fell, so that excess demand for consumption goods was negative (supply exceeded demand). Say’s Law would argue that demand for investment goods would rise to compensate: notional excess demand for investment goods would be positive.

However, as Keynes argued extensively throughout the General Theory, demand for investment goods is driven by expectations of profit, and these in turn depend heavily upon expected sales to consumers. A fall in consumer demand now could lead entrepreneurs to expect lower sales in the future – since in an uncertain environment “the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations, our usual practice being to take the existing situation and to project it into the future.”

Dampened expectations would therefore lead entrepreneurs to reduce their demand for investment goods in response to a reduced demand for consumer goods. Thus a situation of negative excess demand for consumer goods could lead to a state of negative excess demand for investment goods too – a general slump.”

In an earlier draft, Keynes also had another, more straightforward critique of the Law. He seems to have omitted it because it originally came from Marx. This critique is also worth outlining and can be explained in the following way.

Say’s Law begins from the abstraction of an exchange-only economy: an economy in which goods exist at the outset, but where no production takes place. This led economists to believe that if an agent desired to and did accumulate wealth, that would make them a “thief”. However, Marx observed – famously – that production enables agents to accumulate wealth without aspiring to be thieves. Marx formulated this analysis in terms of two ‘circuits’: the ‘Circuit of Commodities’ and the ‘Circuit of Capital’.”

In the Circuit of Commodities, things are as Walras imagined them: people come to market with commodities, which they exchange for money to buy other commodities. Marx stylised this as C – M – C.

In the Circuit of Capital, however, people come to market with money, with the intention of turning this money into more money. “These agents buy commodities – specifically, labour and raw materials – with money, put these to work in a factory to produce other commodities, and then sell these commodities for (hopefully) more money, thus making a profit.” Marx stylised this as M – C – M+

As Keen puts it, “These agents wish to supply more than they demand, and to accumulate the difference as profit which adds to their wealth. Their supply is the commodities they produce for sale. Their demand is the inputs to production they purchase – the labour and raw materials. In Say’s Principle’s terms, the sum of these, their excess demand, is negative. When the two circuits are added together, the sum of all excess demands in a capitalist economy is likewise negative.””

Mitchell himself observes that “it was exactly these issues that Keynes tackled in The General Theory. He quotes Keynes in Chapter 14, a chapter on the classical theory of interest. Mitchell’s quote shows that, for Keynes, once one accepts the claim that there is a ““natural” or “neutral” […] or “equilibrium” rate of interest, namely, that rate of interest which equates investment to classical savings proper without any addition from “forced savings” one has put oneself “in deep water.” As Keynes poetically puts it:

“The wild duck has dived down to the bottom — as deep as she can get — and bitten fast hold of the weed and tangle and all the rubbish that is down there, and it would need an extraordinarily clever dog to dive after and fish her up again.

Thus the traditional analysis is faulty because it has failed to isolate correctly the independent variables of the system. Saving and Investment are the determinates of the system, not the determinants. They are the twin results of the system’s determinants [aggregate demand]. The traditional analysis has been aware that saving depends on income but it has overlooked the fact that income depends on investment, in such fashion that, when investment changes, income must necessarily change in just that degree which is necessary to make the change in saving equal to the change in investment.”

Mitchell translates:

“In other words, the orthodox position that the interest rate somehow balances investment and saving and that investment requires a prior pool of saving are both incorrect. We learned categorically that investment brings forth its own saving through income adjustments.

What drives all this is effective demand – spending backed by cash (Marx definitely wrote about that in Theories of Surplus Value). The 1930s totally discredited the Wicksellian ideas about the dynamics of the economy and the centrality of interest rate adjustments in stabilising the economy.”

We’ll also see later, when I discuss the substantial macroeconomic constraints on government spending and we get to price theory, that the idea that interest rates are key to prices (inflation, deflation) is not a good theory.

After Mitchell’s done dismantling this Wicksellian notion, he gets onto the positive case for having a permanent zero interest rate. His sole argument is that monetary policy is “a poor tool for counter-stabilisation” because “it is indirect, blunt and relies on uncertain distributional behaviour.” He claims “It works with a lag if at all and imposes penalties on regions and cohorts that may not be contributing to the price pressures (for example, when Sydney property prices were booming all of regional Australia[,] which was not[,] was [nevertheless] forced to bear the higher interest rates).” Fiscal policy, by contrast, is “powerful because it is direct and can create or destroy net financial assets in the non-government sector with certainty [, not relying] on any distributional assumptions being made.”

Phillip Pilkington, in this post (http://www.nakedcapitalism.com/2012/12/philip-pilkington-monetary-policy-and-metaphysics-how-economists-try-to-naturalise-terrible-policies-and-disappear-into-their-own-theories.html), explicates similar arguments in much more depth:

“The simple fact is that the era of interest rate targeting has been, well, something of a disaster. That this would have been the case would not have surprised the old Post-Keynesian economists. As Steve Randy Waldman has pointed out over at his excellent Interfluidity blog, the Polish economist Michal Kalecki predicted what would likely happen should central bank’s begin to rely on monetary policy as their primary tool of choice. In 1943 – yes, 1943! – Kalecki wrote:

“The rate of interest or income tax [might be] reduced in a slump but not increased in the subsequent boom. In this case the boom will last longer, but it must end in a new slump: one reduction in the rate of interest or income tax does not, of course, eliminate the forces which cause cyclical fluctuations in a capitalist economy. In the new slump it will be necessary to reduce the rate of interest or income tax again and so on. Thus in the not too remote future, the rate of interest would have to be negative and income tax would have to be replaced by an income subsidy. The same would arise if it were attempted to maintain full employment by stimulating private investment: the rate of interest and income tax would have to be reduced continuously.”

And after 1982 when interest rates began to be used to stimulate economic activity this is precisely what happened. Waldman provides us with this rather stark graph in order to illustrate the confirmation of Kalecki’s thesis:

Yes, the Federal Reserve was able to keep the economy on a growth path – albeit one that was vastly inferior to that during the Keynesian era – but in order to do so they basically had to keep dropping the interest rate after every recession and not bring it back to its previous level after the recovery had set in. What we got then was seriously diminishing returns from monetary policy right up until after the 2008 financial crisis when interest rate targeting became completely ineffective as a means to return the economy to anything resembling full employment.”

“One of the other, often overlooked, negative consequences of using monetary policy as the key tool of macroeconomic stabilisation is that it is, by definition, a tool that uses instability to try to generate stability and this has serious consequences for economic development. Whereas fiscal policy seeks to glide the economy to full employment through delicately balancing effective spending, monetary policy relies on “shocking” the economy in the desired direction. Naturally, this greatly heightens uncertainty amongst the business community.

Imagine a representative firm earning a rate of profit on their investments of 8% per year. Now, if the central bank raises interest rates to stall the economy this will have two negative consequences for the firm in question. First of all, any outstanding debt that the firm has will cost more to service. Secondly, and perhaps more importantly, their prior investments will start looking a lot less promising. If the interest rate is set at, say, 3% then the firm could make 3% merely by buying perfectly safe government bonds. Now, the spread between their rate of profit and this rate of interest – in our example, 8% – 3% = 5% – may be sufficient to compensate for any risk the firm incurs through its investments. But if the rate of interest rises to, say, 4%, these investments may no longer appear worthwhile because the spread between the rate of profit and the risk free rate of interest will be only 4%.

What this means is that firms have to price into their investments the likelihood that the central bank will raise interest rates in the coming year. Thus, as the British Post-Keynesian economists Nicholas Kaldor knew well, if an economy is being stabilised through interest rate manipulation alone, firms will be far more cautious about making real productive investments and will favour speculating in bond and other financial markets. Kaldor put it as such in his seminal 1958 paper “Monetary Policy, Economic Stability and Growth”:

If bond prices were subject to vast and rapid fluctuations [due to the central bank manipulating the interest rate to steer the economy], the speculative risks involved in long-term loans of any kind would be very much greater than they are now [i.e. in the Keynesian era], and the average price for parting with liquidity would be considerably higher. The capital market would become far more speculative, and would function far less efficiently as an instrument for allocating savings – new issues would be more difficult to launch, and long-run considerations of profitability would play a subordinate role in the allocation of funds. As Keynes said, when the capital investment of a country “becomes a by-product of the activity of a casino, the job is likely to be ill-done”.

And things have gone exactly as Kaldor predicted that they would. In our era of monetary policy primacy investors have become far less inclined to pour funds into real investment, as can clearly be seen in the case of the US in the below graph.

The reader can probably make out from that chart that prior to 1969 the average growth in the rate of investment (red line) was significantly higher than after 1969 when monetary policy (blue line) became an increasingly important tool to manage the economy. The average growth in the rate of investment between 1947 and 1968 was 1.31% per year while the average growth in the rate of investment between 1969 and 2012 was 0.9% – a decline of over 31%. If we take the monetary policy era as having started in 1979 rather than in 1969 – we mention this only because it is the typical periodisation, whereas if we look at the data it’s clear that monetary policy came into favour in 1969 – but if we take the year 1979 as our starting point we achieve broadly the same, if not an even more dramatic, result: between 1947 and 1979 the average growth in the rate of investment was 1.25% per year, while between 1979 and 2012 it was 0.78% – a decline of over 37%.

Meanwhile, the capital markets have indeed turned into a giant speculative casino. Interest rate targeting is, of course, not wholly to blame for these shifts, but it absolutely is a key factor. And indeed, most economists and policymakers would claim that this era’s prosperity (or lack thereof), which they refer to as the “Great Moderation”, is a result of the new “scientific” interest rate targeting policies. In reality, by using monetary policy shocks to steer the economy central banks are driving out the good investment and encouraging speculative Ponzi rubbish in the financial markets.”

“If the economy were consistently run at zero-level interest rates, investors would be forced to invest in real goods and services rather than in government and related debt instruments. Given that the economy would also be being run at close to full employment the risks that potential real investors would have to bear would be substantially lower as they could be sure that the government was always guaranteeing that there would be a market for their goods and services. Finally, the interest repayments on borrowing by productive investors would be extremely low, giving even more of an incentive to invest in tangible goods and services.”

Pilkington does, however, suggest that it might not be a good idea to cement the interest rate completely, and in this regard cites the inflation-based argument of one of the major influences of the post-Keynesian tradition, Nicholas Kaldor:

“The other approach that might be taken to monetary policy in a society not run by metaphysicians and haruspices would be the “Kaldorian” or “fine-tuning” approach. In his previously cited 1958 paper, Kaldor noted that although Keynesian policies were extremely good at maintaining a steady rate of investment and growth, they could not deal with fluctuations in the level of inventories.

Capitalists tend to increase investment in inventories when they think an uncertain event might be around the corner – the simplest example of this being a rise in the price of raw materials due to weather conditions. This would cause them to borrow at the short-term rate of interest in order to avail of the lower prices of production, increase their holding of inventories and buffer themselves against future rises in production costs. The problem with this was that if the economy was running close to full capacity (i.e. full employment) any sudden increase in production needed to build up inventories would lead to a squeeze on resources and possible inflation.

Kaldor thus suggested that because capitalists borrowed almost exclusively at the short-term rate of interest to build inventories, it could be increased at times when central banks thought that capitalists were about to build inventory while the economy was at full capacity. Kaldor wrote:

“[The] function of credit control [i.e. monetary policy] should be sought in stabilising investment in stocks (i.e. in offsetting spontaneous tendencies to instability in inventory investment), and not in the control of investment in fixed capital or the control of consumption which can far more appropriately be secured by other instruments.”

Kaldor’s comments can be seen today in light of the fact that it was indeed an external shock to the prices of raw materials (oil) which in the 1970s set off an uncontrollable inflation. But even in his classic essay he remained sceptical that monetary policy alone could secure price stability in case of rises in the price of raw materials. For this reason he also advocated that countries work together to secure buffer stocks of raw materials in case of shortfalls. Today, in light of the events that took place in the 1970s, he might have added policymakers should be mindful of the domestic economic effects their foreign policy decisions might have.”

My overall conclusion is as follows: in an ideal world, we would end central bank independence, perhaps gradually phase out bond issues, but possibly still do some interest rate management such as Kaldor suggested.

Substantial Macroeconomic Constraints on Government Spending:

A standard response to the claim that deficits are good is that inflation will break out if the government prints too much money; the especially vulgar critics seem to think that if governments abandon the goal of running surpluses, it will only be a matter of time before hyperinflation breaks out, à la Weimar Germany or Zimbabwe (this (http://theconversation.com/printing-more-money-isnt-the-answer-to-all-economic-ills-71334), for example, is one of the stupidest articles I’ve ever read, savaged by Bill Mitchell here: http://bilbo.economicoutlook.net/blog/?p=35234). Meanwhile, the majority of mainstream economists believe in something called the “NAIRU”, the Non-accelerating Inflation Rate of Unemployment”, meaning that there is a level of unemployment below which you inevitably get an inflation outbreak.

Marc Lavoie summarises the mainstream view in chapter 8, “Inflation Theory”, of Post-Keynesian Economics: New Foundations:

“In mainstream economics, price inflation is essentially an excess demand phenomenon. In its simplest form, excess demand arises from an excess supply of money, or rather from an excessive growth rate of the money supply. This is the quantity theory of money in its various incarnations, including monetarism. In its Wicksellian version, associated with the New Consensus, excess demand arises from a market rate of interest that is too low compared to the natural rate of interest. More precisely, a negative discrepancy between the market and the natural rate of interest opens up an output gap that leads to an acceleration of the inflation rate, supported by growth in the money supply. This is akin to the accelerationist thesis and the vertical Phillips curve, based on the natural rate of unemployment or the non-accelerating inflation rate of unemployment (NAIRU). Whenever the actual rate of unemployment is below this rate, wage and precise inflation speeds up. The change in the rate of inflation is thus determined by the level of the rate of unemployment relative to its presumed natural value. There are other incarnations of this accelerationist thesis, tied to the rate of capacity utilization, with a steady-inflation rate of capacity utilization (SIRCU).” [2015 edition: 541]

The highly socially right-wing but seemingly incredibly (economically) well-read guy on the internet who calls himself “Lord Keynes” and runs this blog (http://socialdemocracy21stcentury.blogspot.com.au/), gives some more detail on these theories and explains why they’re wrong in this post (http://socialdemocracy21stcentury.blogspot.com.au/2014/04/bob-murphy-on-1970s-inflation.html) and discusses post-Keynesian inflation theory in greater generality in this post: (http://socialdemocracy21stcentury.blogspot.com.au/2011/06/stagflation-in-1970s-post-keynesian.html). These are must-read analyses. I would simply quote extracts from them like I have done with Bill Mitchell’s and Phillip Pilkington’s blogposts, except that I think that there’s nothing to leave out (what is the point of pasting an entire blogpost?).

As for this notion that hyperinflation would be a serious prospect if a First World country with idle resources and labour ramped up spending on useful projects which had a multiplicative effect throughout the economy, Mr. Wray addresses this head-on in this post (http://www.economonitor.com/lrwray/2011/08/31/not-worth-a-continental-how-modern-money-theory-replies-to-hyperinflation-hyperventilators-part-2/), by examining the specific constellation of factors which lead to hyperinflation (collapse of output because of some war or disaster, necessity to pay significant external debts, etc). I will now extract the key section of this post:

“It is important to examine the relation between budget deficits and high or hyperinflation. When Luiz Carlos Bresser-Pereira was finance minister for Brazil during a high inflation period he provided an insightful analysis of the alternative. In an important sense, tax revenues are “backward-looking”, based on past economic performance. Income taxes, for example, are calculated and collected with a rather long lag. Even sales taxes are collected with a lag. When inflation is running at 2% per year, the lag does not matter much; but if it is running 10% or 50% per month, even a short lag makes a big difference. Government spending is more contemporaneous—as prices rise, government pays more.

Of course, this effect will depend on indexing—how often are the wages, prices, and transfer payments increased as prices rise. In countries, like Brazil, with high inflation, the reset period for indexing tends to fall—so that government spending rises nearly as fast as inflation. With tax revenues growing more slowly, a budget deficit is created. Of course, indexing also tends to build-in inertial inflation (a wage-price spiral is created as rising prices trigger wage increases that induce firms to raise prices to cover costs). Bresser realized that the way to reduce growth of the deficit and to cut inflation was to check indexing. While it is painful, if government can postpone the increases to wages, welfare payments, and prices paid by government, it can reduce inflation pressures and at the same time reduce the budget deficit.

The important point to note, however, is that budget deficits are at least to some degree an effect, not a cause, of inflation. Still, it is true that if government reduces its deficit (by eliminating indexing, for example) it will reduce inflation pressures. To be sure, it can achieve the same result through draconian tax hikes. Note also that this policy recommendation is not inconsistent with the conventional view that fiscal austerity can reduce high inflation. Indeed, MMTers have always agreed that one way to fight high inflation is to cut government spending or to raise taxes. What they reject is the Monetarist belief that the cause of high inflation is a simple matter of “too much money”.

There is a link among high (or hyper) inflation, budget deficits, and “money supply”—although it is not a simple Monetarist dynamic. As discussed, government always spends by “keystrokes” that credit accounts, and taxes (or sells bonds) by reverse keystrokes that debit accounts. Deficits mean government credited more to accounts than it debited, so that government IOUs have been net created in the form of “high powered money” (HPM or reserves plus cash) and treasuries (bonds and bills). As discussed above, in high or hyper- inflation periods, taxes (debits to accounts) grow more slowly than government spending (credits to accounts) so we expect deficits to result—which means government IOUs outstanding (HPM plus Treasuries) grow.

This is not the simple Monetarist story in which government “prints too much money” that causes high inflation, but rather a more complicated causal sequence in which high inflation helps to create deficits—that by identity equal net credits to balance sheets. Matters are made worse if a high interest rate policy is pursued by the central bank. This is because government typically sells a lot of treasuries as its deficit rises (sometimes this is actually required by operating procedures adopted, or it is due to a policy of setting the overnight interest rate target above the support rate—in the US this would be a case where the Fed’s fed funds target was above the rate it pays on excess reserves), and interest payments on treasuries add to government spending. If the central bank reacts to growing deficits by raising interest rate targets, it helps to fuel  growth of the deficit and also adds demand stimulus to the economy.

Stopping the inflation (for example by eliminating indexation of government spending) will probably reduce the deficits and the growth of HPM and treasuries outstanding. (That will also reduce interest payments by government, slowing growth of nongovernment incomes and depressing demand.) Alternatively, accelerating tax collection would achieve the same goal. Lowering the interest rate target could also help.

Let us turn to historical episodes with hyperinflation. America has had two such well-known experiences: the “Continentals” and the Confederate currency (we still have the phrase, “not worth a Continental”). In the pre-revolutionary period, the American colonies actually experimented fairly successfully with paper “fiat” currencies. To some extent, this was emergency behavior–they were prohibited by the Crown from coining currency. Some commentators at the time—including Adam Smith—noted that even though these notes were not redeemable for precious metal, they maintained their value so long as the issue was not too excessive relative to total taxes. As MMTers say, “taxes drive money”—so long as paper IOUs of government are accepted in tax payment, they will be accepted in payment. Still, their value will be determined by “how hard” they are to obtain. If money “grew on trees” (as our mothers used to say), it would be worth only the effort required to pick it. If colonial governments spent too much into existence so that it was easy to obtain paper notes to pay taxes, then they would circulate at lower value.

Both the Continentals and the Confederate currency shared common defects. First, the requirements of wars (Britain vs the colonies, North vs South) made the currencies overly abundant. Certainly there is nothing new about that—wars generally do experience inflation as government spending ramps up demand, causes shortages, and chases prices up. However, that was also true of the currency issued in the Union—which suffered from very high inflation, but not nearly so bad as that experienced in the South. The difference was taxes—essentially there were no taxes backing either Continentals or the Confederate currency. In the first case, the loose confederation of the colonies did not have sufficient authority to impose and enforce taxes; in the second, the representatives of the Confederate states believed that the population was already suffering too much from prosecuting the war of rebellion—so did not want to add the burden of taxation. By contrast, even though the North ran large deficits, it retained a tax system to drive the currency and thus avoided hyperinflation. While it might be thought that the South’s much worse experience can be attributed to pessimism over its prospects of winning, that does not seem to be the case.  Even near the end of the war, when prospects were bleakest, the Confederacy was still able to float bonds at relatively low interest.  (For those who are interested in these cases, see my book, Understanding Modern Money for more discussion.)

Today, the best known cases of hyperinflation occurred during the Weimar Republic and more recently in Zimbabwe. (Less well-known but more spectacular was the Hungarian hyperinflation.) The best analyses of these that I have seen are by William Mitchell (at billyblog: http://bilbo.economicoutlook.net/blog/?p=10554; http://bilbo.economicoutlook.net/blog/?p=13035), Rob Parenteau  http://www.nakedcapitalism.com/2010/03/parenteau-the-hyperinflation-hyperventalists.html, Cullen Roche http://pragcap.com/hyperinflation-its-more-than-just-a-monetary-phenomenon , and at http://rabble.ca/print/blogs/bloggers/progressive-economics-forum/2011/08/mythologies-money-and-hyperinflation. Cullen actually looked at 10 modern (post 1900) hyperinflations and found several common themes. First, most of the ten occurred during a civil war, with a regime change. A majority also occurred with large debt denominated in foreign currency (this included Austria, Hugary, Weimar Germany, Argentina, and Zimbabwe). I am not going to reproduce these excellent analyses, but let me just very quickly summarize key points about the Weimar and Zimbabwe hyperinflations to assure readers these were not simple cases of too much “money printing” to finance government that was “running amuck”.

The typical story about Weimar Germany is that the government began to freely print a fiat money with no gold standing behind it, with no regard for the hyperinflationary consequences. The reality is more complex. First, we must understand that even in the early 20^th century, most governments spent by issuing IOUs—albeit many were convertible on demand to sterling or gold. Germany had lost WWI and suffered under the burden of impossibly large reparations payments—that had to be made in gold. To make matters worse, much of its productive capacity had been destroyed or captured, and it had little gold reserves. It was supposed to export to earn the gold needed to make the payments demanded by the victors. (Keynes wrote his first globally famous book arguing that Germany could not possibly pay the debts—note these were external debts denominated essentially in gold.)

The nation’s productive capacity was not even sufficient to satisfy domestic demand, much less to export to pay reparations. Government knew that it was not only economically impossible but also politically impossible to impose taxes at a sufficient level to move resources to the public sector for exports to make the reparations payments. So instead it relied on spending. This meant government competed with domestic demand for a limited supply of output—driving prices up. At the same time, Germany’s domestic producers had to borrow abroad (in foreign currency) to buy needed imports. Rising prices plus foreign borrowing caused depreciation of the domestic currency, which increased necessitous borrowing (since foreign imports cost more in terms of domestic currency) and at the same time increased the cost of the reparations in terms of domestic currency.

While it is often claimed that the central bank contributed to the inflation by purchasing debt from the treasury, actually it operated much like the Fed: it bought government debt from banks—offering them a higher earning asset in exchange for reserves. For the reasons discussed above, budget deficits resulted from the high and then hyper- inflation as tax revenue could not keep pace with rising prices.

Finally in 1924 Germany adopted a new currency, and while it was not legal tender, it was designated acceptable for tax payment. The hyperinflation ended.

To say that Weimar’s hyperinflation simply came down to a matter of government “printing money” is obviously far too simple. Let us turn to Zimbabwe. Here is a country that was going through tremendous social and political upheaval, with unemployment reaching 80% of the workforce and GDP had fallen by 40%. This followed controversial land reform that subdivided farms and led to collapse of food production. Government had to rely on food imports and IMF lending—another case of external debts. With food scarcity and government and the private sector competing for a much reduced supply, prices were pushed up. This was also another case in which government could not have raised taxes, for both political and economic reasons. Again, to label this a simple Monetarist case of government “printing money” really sheds no light on Zimbabwe’s problems.

My point is not to argue that greater constraints on government spending (or greater capacity to increase taxes) might not have successfully prevented inflation. However, as one studies specific cases of hyperinflation one recognizes that it is not a simple story of government adopting a fiat money and suddenly it finds itself printing so much that it causes hyperinflation. There are probably many paths to hyperinflation, but there are common problems: social and political upheaval; civil war; collapse of productive capacity (that could be due to war); weak government; and foreign debt denominated in external currency or gold. Yes, we do observe rising budget deficits and (really by identity) growing outstanding government IOUs. But we also find banks creating money (more next week) to finance private spending that competes with government to drive up prices. And, yes, tighter fiscal policy would have helped to reduce inflationary pressures. This probably would not have reduced overall suffering, since a common cause of hyperinflation is some kind of supply constraint on output.”

Recently, the investor Richard Vague and colleagues undertook a massive study, using a database of 47 countries from 1960 to 2015, on the link between “rapid money supply growth” and inflation (as well as looking specifically at the role of rapid growth in government debt, declining interest rates, and rapid Increases in a central bank’s balance sheet). Their overall conclusion was as follows: “In the majority of cases, it was not. In fact, the opposite was true—a large percentage of the cases of high inflation were not preceded by high money supply growth. These 47 countries all rank within the top 70 largest economies as measured by GDP and include each of the top 20 countries. If a country was not included, it was because we could not get a complete enough set of historical data on that country.” The paper can be read here: http://evonomics.com/moneysupply/.

 Once more, here’s my overall conclusion: First World countries would not face a hyperinflation risk if they were more fiscally expansive and tried to kickstart their ailing economies with a Sanders-type programme. If a country like the US implemented a major infrastructure now, using entirely public funds – spending tens of billions of dollars in one go – there would still be not a chance in hell of excessive inflation. There may well be some increase in inflation, because of the big leap in employment, but this stimulus would have effects throughout the economy, increasing general demand, leading to more and more economic activity and more and more production. This kind of spending, unlike QE, would have a true ‘multiplier effect’.

It is true that inflation is the big domestic constraint on wanton government spending, and it is true that if there is a high-level of employment and wage claims become too high, then inflation becomes a problem. But this in itself does not show that the inflation-targeting-regime which followed the Neoliberal assault of the late 1970s has been in any way a sound compromise. It has been entirely the opposite (and we’ll discuss this more when we get to the end, and our final appraisal of the question of how governments should run themselves).

Apart from inflation, the other major macroeconomic constraints on government spending are related to trade: they come from consideration of the exchange rate and the current account balance of a nation. These are, in fact, quite significant constraints (though their significance varies massively by country, with America in the least constrained position, for reasons we’ll see).

As Mr. Wray explains here (http://neweconomicperspectives.org/2011/11/mmp-blog-25-currency-solvency-and.html (though he is guilty of underemphasising this problem, and the US’ uniqueness, as articulated here: http://nakedkeynesianism.blogspot.com.au/2012/07/spurious-victory-of-mmt.html)),

“If a nation runs a current account deficit, by identity there must be a demand for its assets (real or financial) by someone with foreign currency. (A foreigner could either demand the nation’s currency for “direct investment” that includes buying property or plant and equipment, or the foreigner could demand financial assets denominated in that currency.)   If that demand for assets declines, then the current account deficit must also decline.”

 For many reasons – not least that the US dollar is the international reserve currency – US dollar-denominated assets are highly desirable around the globe. To a lesser degree, the financial assets denominated in UK Pounds, Japanese Yen, European Euros, and Canadian and Australian dollars are also desired. For the US, it is very easy to run persistent current account deficits (and they have been doing so since Nixon) – this helps fund their massive imperialist projects abroad. For the countries mentioned, current account deficits are also not a major problem (though none of these other countries could have run the persistent current account deficits of the US).

In stark contrast, however, many developing nations cannot find a foreign demand for their domestic currency liabilities. As Wray puts it,

“Indeed, some nations could so constrained that they must issue liabilities denominated in one of these more highly desired currencies in order to import. This can lead to many problems and constraints—for example, once such a nation has issued debt denominated in a foreign currency, it must earn or borrow foreign currency to service that debt. These problems are important and not easily resolved. […]

If there is no foreign demand for IOUs (government currency or bonds, as well as private financial assets) issued in the currency of a developing nation, then its foreign trade becomes something close to barter: it can obtain foreign produce only to the extent that it can sell something abroad. This could include domestic real assets (real capital or real estate) or, more likely, produced goods and services (perhaps commodities, for example). It could either run a balanced current account (in which case revenues from its exports are available to finance its imports) or its current account deficit could be matched by foreign direct investment.

Alternatively, it can issue foreign currency denominated debt to finance a current account deficit. The problem with that option is that the nation must then generate revenues in the foreign currency in order to service that debt. This is possible if today’s imports allow the country to increase its productive capacity to the point that it can export more in the future—servicing the debt out of foreign currency earned on net exports. However, if such a nation runs a continuous current account deficit without enhancing its ability to export, it will almost certainly run into debt service problems.”

One might wonder how directly this relates to government spending. The problem is as follows:

A government deficit can contribute to a current account deficit if the budget deficit raises aggregate demand, resulting in rising imports. By fuelling import growth, this plunges the current account into further deficit which then leads to depreciation (if the exchange rate is floating) or a foreign reserve drain (if it is pegged). This, in turn, leads to expectations of further depreciations and the currency is sold short by hedge funds. This creates disaster.

This is not to say that the MMTers haven’t replied to this worry. Bill Mitchell replies directly to it here (http://bilbo.economicoutlook.net/blog/?p=5644). One extract from this post is particularly relevant:

“But a nation might have a food supply problem just because of location. Then they have to import food. For example, in Kazakhstan where I am working at the moment, they face really significant problems in winter getting fresh vegetables and fruits. Many of these nations also have very little that the World wants by way of their exports. The fact that such a country’s national government is sovereign in its own currency and can spent how ever much it likes in that currency will not solve the problem – there is not enough goods and services (in this case) food for the sovereign government to purchase.

In those situations, a country requires foreign goods and they need to export to get hold of foreign currency or receive development assistance from the rest of the World. In the latter case, I see a fundamental change is required in the role of the IMF (more or less back to what it was intended to do in the beginning). Where are [sic] country is facing continual current account [sic] and currency issues as a result of the need to import essential goods and services, the IMF might usefully act to maintain currency stability for that country.

So as well as the Tajiks desiring their own currency the IMF might also stockpile it in order to stabilise the exchange parity. If this policy was pursued then much of the fears that are raised about currency runs and whatever would be allayed.”

He also points out that the people who draw attention to this (real problem) never really say the same thing about private investment boom which suck in imported productive capital: “Somehow adding productive capacity in the private sector is ‘more efficient or more productive’ than, for example, a large-scale public education policy which increases the capacities of the population in both the workplace but also general life.”

Ultimately, though, it remains true that, as Lord Keynes explains here (http://socialdemocracy21stcentury.blogspot.com.au/2012/07/some-serious-criticism-of-mmt.html ) and here (http://socialdemocracy21stcentury.blogspot.com.au/2016/02/limits-of-mmt.html), the idea that governments should open their purses until they reach full employment is probably only a sensible prescription for the following countries/regions:

(1) the US, 

(2) those nations with strong trade surpluses (Germany (if it were outside the EU), Switzerland, Japan, South Korea or Tawain), 

(3) those nations that seem to run near perpetual current account deficits but attract a lot of foreign capital (say, Australia), and 

(4) the Eurozone, if it were suitably reformed with a union-wide fiscal policy

In a later instalment of this series of economics, I will examine the question of whether Keynes’ proposal for the ‘Bancor’, a supra-national currency, and an International Clearing Union – a proposal that the Chinese government supports – is a superior system for our global economy than our current system where major economies largely operate with floating exchange rates. Keynes’ proposal is something that all the prominent MMTers seem to disagree with about as vehemently as the America-orchestrated international trade system that was actually set up after World War II. Ultimately, however, I will argue that they’re wrong to have this attitude, because Keynes’ system would probably be better for the world as a whole.

Final Appraisal: Deficits or Surpluses?
Contrary to the ‘conventional wisdom’ of the ideologues, shills and buffoons who make up much of the financial and economic commentariat, for a sovereign country to run an overall surplus (as opposed to a current account surplus, obviously) is a bad idea, in general. It is impossible to run a surplus when things are going really bad (because of “automatic stabilisers” like the fact that you take in less revenue when people are losing jobs, welfare payments are rising and stimulus packages/bailouts have to be introduced), which means that surpluses can only be run in conditions of relative economic health or ‘stability’ (bear in mind that national economies are complex, dynamic systems so there’s no such thing as true stability). Yet by running surpluses in conditions of relative economic health, governments guarantee future economic sickness.

To understand why, you must think in terms of sectoral balances and you must understand the nature of money creation. There are only two institutions which create money in society: the government and private banks. As I have gone over previously, banks do indeed create money through loans in a perfectly straightforward sense; credit is money, albeit money that is destroyed when it is paid back. When a government runs a surplus, what this means – as I’ve also explained – is that it takes more money out of the economy than it puts in. Quite apart from the terrible long-term social and cultural costs that typically result from surplus-motivated government ‘cost-slashing’ on education, the arts, health, public amenities, infrastructure and so on (and governments never ‘fix’ their budgets by ending corporate subsidies for their pet industries or raising taxes on the superrich, they always attack the things that bind societies together and make life worthwhile), running a surplus inevitably leads to banks taking on a bigger role through their powers of credit-creation: thus private debt-growth accelerates and asset bubbles inflate. Clinton’s surpluses from 1997 to 2001, peaking at $236 billion in 2000, directly paved the way for the Dotcom bubble and were undoubtedly the most high-level factor in helping to inflate the massive US housing bubble that ultimately led to the subprime loan crisis and the GFC.  John Howard’s surpluses in Australia helped massively pump up the housing bubble in Australia, paving the way for today’s obscene house prices and our crisis of private-indebtedness, which has created a genuine generational apartheid, with the vast majority of people under 30 literally forced to make a choice between leeching off their parents or renting in mouldy decrepit hovels. Australia is now at the point where household debt is 125% of GDP (the highest in the world) and private debt to GDP is over 220%. And recession is coming.

The neverending EU crisis is perhaps the greatest illustration of the truth that, unless they are massive exporters with a world-class manufacturing sector like Germany, nations cannot survive unless they are allowed to run deficits. Indeed, the number of children living with their parents is highest among EU countries, as you can see from the figures on the graph here: http://www.smh.com.au/comment/chart-watch/australian-twentysomethings-join-the-worldwide-trend-of-living-with-mum-and-dad-20161114-gsovsd.html. This review of recent books by Yanis Varoufakis, James Galbraith and Joseph Stiglitz on the EU just about sums it up: https://www.yanisvaroufakis.eu/2016/10/19/europes-ugly-future-a-review-of-varoufakis-galbraith-stiglitz-foreign-affairs/.

Just about every major industrialised/ ‘post-industrial’ country in the world right now, in our debt-deflated, stagnant global economy, would benefit from greater government spending. Deficits are a good thing. That’s a fact.