Wednesday, September 26, 2012

One more economics rant

Everything changed in 1971.  Well, almost everything.  Economics textbooks didn't change, and some laws that are now meaningless didn't change.

What happened in 1971?  We went off the gold standard, and fixed exchange rates, so now the dollar, and all the other major currencies in the world, are fiat currencies, and their values float against one another in the foreign exchange markets.

The implications of this change are profound, and largely unrecognized.  Under the gold standard, the treasury promises to exchange dollars for gold, or vice verse, at a fixed price.  That means there must always be enough gold in Fort Knox to satisfy the demand of anyone who wants to trade their dollars in for gold.

On the gold standard, the government must be careful not to create more dollars than people are willing to hold, lest the people turn in their dollars and the government gold reserves be exhausted.  If government finds itself running short of gold reserves, it will have to devalue its currency, changing the price of gold at which it will make the exchange.  "You can't print gold."

Today, a dollar cannot be traded in for anything except another dollar.  The government can create all the dollars it needs to create, and is no longer limited by the amount of gold reserves it holds.

A government that is the sole issuer of its own fiat currency is said to be monetarily sovereign.  Before computers, a monetarily sovereign government could print all the paper money it needed.  Today, it need not even take the trouble to do that.  Money is created by keystrokes on computers.  The government creates money by instructing a bank to increase the balance in an account.

A monetarily sovereign government can never become insolvent in its own currency.  It can always create whatever amount of money is needed to pay its debts.  The notion that the US government is "broke", or "running out of money", is pure nonsense.  The idea that some day the government will not be able to pay dollars of "unfunded" retirement benefits it has promised, or dollars of medical benefits it has promised, is also nonsense. 

A monetarily sovereign government is not like a household.  Households cannot create money, and their spending is limited to what they can earn or borrow.  A monetarily sovereign government can create money, and need not earn or borrow it.

State and local governments are not monetarily sovereign.  They cannot create dollars.  Only the US Federal government can create US dollars.  State and local government spending is limited to what they can tax or borrow, and the interest rate they pay on their debt is set in the bond market.  If their ability to service additional debt is questioned, then the interest rate they must pay will rise.  

The Euro nations are not monetarily sovereign.  Greece cannot create Euros.  Only the Eurpoean Central Bank can create Euros.  Greece is in the same position as California or Illinois.  The US is not Greece.

The monetarily sovereign government has no need to borrow the money it has created in order to spend.  Why would it borrow, when instead it can create the money it needs with a few keystrokes?  The answer is that there are laws, left over from the bygone era of the gold standard, regulating how the government can create money.  These laws are obsolete.

Likewise, the monetarily sovereign government has no need to collect taxes in order to spend.  It can create the money it needs using keystrokes. Why, then, do governments tax?  Again, there are laws left over from the bygone era of the gold standard, regulating how the government must tax and spend.  But besides those laws, there is an important theoretical reason for taxes, and an important operational reason.

The theoretical reason for taxes is to give value to the currency.  After all, if fiat money is only a piece of paper or a number in a bank account, why would anyone want it?  What value does it have?  The answer is that it is the thing that is accepted by the government in payment of a tax liability.  If you owe a tax, you must acquire dollars to pay it, or they put you in jail.  This is what gives fiat money its value.

The operational reason is that taxing destroys money.  It is the opposite of government spending, which creates money.  Without taxing, or with too little taxing, the amount of money could increase faster than the amount of goods and services produced in the economy.  If that were to happen, the result would be price increases.  Persistent general price increases are known as inflation, and too much inflation is a bad thing.  Taxes are the way government can ensure that its spending does not create money too quickly.

So, if government can spend without taxing or borrowing, what is the meaning of the annual deficit and the accumulated debt of a monetarily sovereign government?  The annual deficit is, of course, the excess of spending over taxing in a given year.  If taxing exceeds spending, the excess is called a surplus.  The amount of the deficit or surplus is the amount of money added to, or subtracted from, the economy in that year.  It is axiomatic that a large economy requires more money than a small one, and from that it follows that a growing economy requires a growing stock of money.  The deficit is what creates money, so a growing economy requires a deficit, every year.  Balancing the budget, or running a surplus, will prevent the growth of the economy.  A too-small deficit will allow for some growth, but will restrict growth and cause unemployment as the labor force expands faster than the stock of money.

A GROWING ECONOMY REQUIRES A DEFICIT.  Proposing to balance the budget, or run a surplus, is proposing to create a recession.

Because the government has been prohibited by law from running a deficit without issuing an equal amount of Treasury securities, the accumulation of annual deficits and surpluses is equal to the so-called National Debt, which is the outstanding stock of Treasury securities.  The meaning of this number is that it is the amount of money that has been added to private sector financial assets, or savings.  The debt of the government is the asset of the people.  It is their accumulated savings.

If the obsolete laws were repealed, the monetarily sovereign government could pay off the national debt, merely by taking back the Treasury securities and giving dollars for them, or redeeming them at maturity and not issuing new ones.  A good portion of the outstanding US Treasury securities are held by the Federal Reserve and the Social Security Trust Fund.  Exchanging them for dollars would have no economic effect whatsoever.  Many of the other holders of Treasuries, including pension funds and foreign governments, would not be pleased, as they would be deprived of their source of risk-free interest.  Therefore there is a reason to have Treasury securities even though the government has no need to borrow its own currency:  it is to provide an interest-bearing alternative to those who wish to hoard (the economist's word for "save") the currency.

Some math:  GDP = Private sector spending + Government spending - net imports

If you want more GDP, you raise private sector spending ability (i.e., cut taxes or increase transfer payments) or raise government sector spending.

If you want less GDP, you lower private sector spending ability (raise taxes or cut transfer payments) or cut government spending.

When unemployment is too high, you need more GDP.

Isn't that easy?

Some more math:  in a closed economic system, no one can save unless someone else dissaves.  Given a fixed amount of financial assets, if one sector of the economy sees a surplus (an increase in their financial assets) then another sector must have seen a decrease (deficit).  The economy is commonly divided into three sectors:  government, domestic non-government (or private), and foreign.  The foreign sector's savings is called the trade deficit.  When China, for instance, sells us more stuff than we sell them, they have a trade surplus and we have a trade deficit.  They are accumulating dollars (financial assets), and we are accumulating goods (real assets).  I've already described the government surplus and deficit.  The private sector, you and me, also has either a surplus or a deficit.  If we spend less than our income, we have a surplus, which is added to our stock of savings.  If we spend more than our income, which happened during the housing bubble, we have to borrow the difference (or reduce our stock of savings) and we have a deficit.

Government surplus + foreign surplus + private surplus = 0

This says that we can't all be saving at the same time.  If one is saving, then one or more of the others must be dissaving.  If one is in surplus, then at least one of the others must be in deficit.

The foreign sector currently and persistently has a surplus, which is our trade deficit.  If we want the private sector also to have a surplus, which is a good thing, then it is mathematically certain that the government must have a deficit, and it must be equal to the sum of the trade deficit and private sector savings.

If we rearrange the equation,

Private savings = Government deficit - trade deficit

If the trade deficit is a positive number (our imports exceed our exports), then in order for private savings to be positive, the government must be in deficit and its deficit must be higher than the trade deficit.

The nature of money and government fiscal operations for a fiat currency is described by an economic system called Chartalism, also known today as Modern Monetary Theory.   The content of this article is taken from MMT principles and teachings.  There has been much more written at and

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