On money

I recently sent A an article explaining why the deficit terrorists are wrong and why we need bigger deficits. It was a bit on the dry side, and she said she didn't really get it, so I'm going to try to explain in easy terms.

The first thing to get straight is this: we are led to believe that sovereign governments are like households. They achieve an income (in the form of taxation) and then spend it. If they don't have enough, they borrow what they need. This is entirely the wrong way round.

In fact, governments set spending plans and then spend by crediting bank accounts. They do not need money to do this because their spending creates the necessary money. It's important to understand that in a fiat-money system, governments do not get money from anywhere. They simply issue it. They are able to do this because they have a monopoly on money creation (of course, banks create it too, but we won't complicate this story by discussing bank creation of money). I often say, if you had a money tree in your backyard, you would not need a credit card.

"Fiat" means that money is whatever the government says it is, rather than something that has intrinsic value. Forty years ago, money was backed by gold, so that the US government had to back each dollar with an amount of gold. This is no longer the case.

The government's money has value because it is the only thing it will accept to extinguish tax obligations. So everyone must have money because they must pay taxes. (And if this wasn't true, we could not have fiat money.) So the government takes in tax money but it doesn't use it to pay bills or anything like that. It simply credits its accounts, in effect destroying the money. This is in fact the fundamental purpose of taxation: to reduce liquidity in the system. The government puts money in by spending, and withdraws it by taxing.

Only then does the government "borrow" money. It "pays" for its shortfall by issuing debt dollar for dollar. In fact, it should be clear that given that it has no requirement to "pay" for anything (because unlike you, it doesn't have to acquire money but can simply create as much as it needs), the debt it issues is simply a store for excess value in the economy. In other words, it is a way for the private sector to save the excess of its wealth after taxation.

It is probably not quite so clear that the government cannot in fact control deficits, except by setting spending so abysmally low that even a very poorly performing economy can generate enough taxation to "pay" what it has spent. In a recession, taxation falls and welfare payments rise, leading to a shortfall that the government cannot do anything about. If it raised taxes, it would simply withdraw even more money from the economy, lessening demand even further; same if it spent less. This process of generating a deficit is automatic. (The government can of course plan to run a deficit by planning to spend more than it plans to tax--note that in fact if the economy boomed in some unexpected way, and tax receipts rose sufficiently, the government would not be successful in running a deficit either!)

Something that people don't really grasp is that issuing debt is purely voluntary. The government does not have to do it at all. It can spend what it likes, so long as there are things to buy in its own currency. With 10% of the population out of work and factories idle, it's clear that there's plenty to buy. The government could cease to issue debt tomorrow and simply run unfunded deficits. Nothing would change except that rich investors would not be able to leech off our economy in this particular way. The reason it does not is purely ideological: conservatives invented the "balanced budget" as a way to discipline progressives, who they fear would if not checked spend money on social goods that would benefit the masses. I am not kidding. The only reason the government restricts its spending is so that you do not get your share of the value of your nation's economy.

Some argue, and certainly I do, that the government's role in the economy is to create an environment in which all have work and can assure their wellbeing. The way it works is not difficult to understand. People buy things and business supplies those things. If people want more of the things, business hires more people to provide them. If they want less, they lay people off. People want more or less for various reasons: at the moment, less because the economy is poor and people are not confident it will improve, and already carry too much debt.

The government can (and should) make up for the deficiency in spending. It can demand goods and services sufficient to provide work for everyone who wants it. It doesn't really matter what it demands (Keynes said it could pay people simply to dig holes and then fill them back in) but of course it could put people to work on useful projects. Imagine. The US government could build light rail in all its cities, new roads, new port infrastructure (few American ports can handle the new generation of container superships), new school buildings, employing everyone who needs a job.

Isn't that inflationary? If the government creates new money, doesn't that cause prices to go up? Well no. Inflation is not caused by more money; it is caused by more money chasing the same goods. If the economy is not working at full capacity, and demand is deficient, the government would not be competing with others for the same resources or goods. It is only when the economy is reaching full output that the government must step back. The only time a government needs to "balance the books" is when the economy is at full output.

Finally, I want to explain that surpluses are in fact bad for the economy, which is why they are so rare, thank goodness. Ignoring exports, the government's budgetary outcome is like this:

Spending = Receipts from taxation + borrowing

If the government balances its budget, borrowing is zero, so spending and taxation are precisely matched. This means that there is nothing left over for people to save! If the government runs a surplus, it takes more money out of the economy than it puts in, so people must dissave to pay taxes.

Be clear, there is nowhere else for the money to come from! If the American government does not spend US dollars, there are no US dollars. When we say that the Chinese "lend" the US dollars, we do not mean that China creates the dollars. It simply buys US dollar assets, which is a way for it to place its surplus wealth into US dollar form. (The US does not need to permit this, although there is good reason to allow China to acquire dollar assets. It's not the big problem people think: the US could pay China back by simply crediting certain accounts. Hang on, you're thinking, wouldn't that piss the Chinese off? Their money would be worth a bit less, right? Well no, because the value of money is not set by how much of it there is but by what each unit can buy, which would not change significantly. And the truth of it is that the Chinese buy US dollar assets precisely because the US government can always pay them back: they're safe as houses because the US can simply get the money from thin air if it chooses to.)

If the US government ran a surplus in perpetuity, it would in time remove sufficient value from the economy that it ceased to function. No one would have any US dollars to buy things with. Long before that happened, of course, the revolution would have carried the current form of government away. But if it "balances the books" now and then, to the detriment of the population, this has the effect of maintaining the value of fixed assets like land or gold, which have value in themselves and not just because you can get US dollars for them. Guess who likes the policy of reducing the deficit?

posted by Dr Zen @ 9:39 am