Rhetoric Is A Powerful Tool To Advance Moneyed Interests

Money is essential to a successful economy.  But it’s money in circulation that’s useful.  Money that’s locked up in storage in vaults and savings doesn’t help.  The early economists understood this well and often used the analogy of money-is-to-economy as blood-is-to-human-body.  Circulating money, money that is used to buy things is as important to the economy as the blood in your arteries and veins.  The analogy works.  It leads us to realize that money, and more of it, can and usually is a good thing.

The analogy, however, doesn’t work for those economists and policy-makers who want are more interested in enabling the top 1% or so to profit at no risk by earning income on holding money.  Theoretically, the rich, the top 1%, could earn income from their large stores of wealth by investing it in production.  But the profit-by-investment-in-production method requires risk. It’s hard. It requires work to find and exploit good investment opportunities. From the perspective of the really wealthy, it can be more desirable to make money by simply owning money.  To do that, it’s necessary to that there be no inflation. They actually prefer deflation because then their cash wealth gets more valuable without being risked or used productively at all. The other approach to making money without risk by simply owning money is to lend it. Instead of starting, owning, and building a business, investing in equity, you make loans. Ideally you use your wealth and influence to get politicians to guarantee your loans – heads you win and tails somebody else loses. These approaches to making money by simply owning money require that money be scarce and hard to get.  It’s directly counter to the money in circulation paradigm.  A circulatory system deprived of money is good thing those who make money from money instead of labor.

But to persuade the mass of people, the 99%, the ones earning money from labor, it’s necessary to change the metaphor.  That’s been rather effectively in the second half of the 20th century.  It’s been done by extending a different metaphor.  Economists have long used the word liquidity for the idea of how easy it is to convert an asset into cash and therefore spent. For example, real estate (particularly in this market) is very illiquid.  I could own a $1 million house but be unable to buy a Coke from the 7-11 store because I lack any cash.  That’s an extreme example of illiquidity.  In contrast, a liquid asset is one that is either actually cash or easily turned into cash so it can be spent.  There’s a whole range of assets in between with varying degrees of liquidity.

This idea of liquidity and it’s association with cash has been used to push a metaphor that suggests the problem is too much money in the economy.  We’re peppered with phrases like “drowning in debt” or a house mortgage that is “underwater”.  It makes us feel that the liquid stuff is undesirable.  So we get  a central bank that’s reluctant to create and inject money into the economy because critics claim that will create too much liquidity and they falsely claim that it’s inflationary.  When the central bank does increase inject liquidity into the economy, it does it by getting the money to precisely the people who keep it from circulating.  We get a government that refuses to use it’s ability to directly inject money into the economy and get it into circulation.

Government ultimately is the source of all money.  Only government can define and create money.  It has two ways to do it. It can simply create (“print” or “mint” if you will, but it’s not that way anymore) money and spend it.  That puts money immediately into circulation in the circular flow of goods and services.  Or, the government could create money reserves for the banks, a riskier strategy.  The banks then can lend using a fractional reserve logic.  If the banks lend out the reserves, then money is created.  If the borrowers from the banks spend the borrowed money, then it’s in circulation.  If the borrowers use the money to simply buy other financial assets, then it’s not in circulation and is sterile.

In our modern system, the government (in the U.S. and many other nations) has delegated the responsibility for creating money and putting it into circulation to quasi-private central banks such as The Federal Reserve Bank.  In today’s workings of the financial system, these central banks have further delegated the responsibility and decision-making on money-creation to private commercial banks by providing reserves for whatever level of loans they choose.  When those banks choose not to create money or choose not to create and provide money in a way that puts it into circulation, the system suffers. We suffer from too little liquidity.

Daniel Becker at Angry Bear made this point very well in a long post there in June 2011.  He points out that we should really talk about “dehydrating in debt”, not “drowing in debt”.  The dehydration metaphor leads us directly to the solution – more money in circulation.  I from the conclusion to his post:

Got that? Let’s summarize: The share of income to the 99% of people declined from 1976 onward. At the same time the means of making money changed from labor production to money manipulation (producer economy to finanicialized economy) adding to the reduction in share of income. We also changed the ideology to one from relying on the vast population (as represented by the individual and We the People) to relying on a small portion of the population to distribute what money was created. We did this for 33 years. By 1996, people were borrowing as a means to sustain their standard of living (not increase it). If the people are not spending to increase their standard of living, then is the economy really growing? By 2006 people were no longer able to make the payments and consumption was declining.  Then gas hit $4/gal and winter heating was looking like another $4000 to $6000 would be needed.

To date, nothing has been done to address this. Nothing at all. And, by “this” I mean, the income inequality that has resulted in an an economy where a very small group of people (top 1%) are taking money out of the system (that is money that would fuel the engine) faster than the engine can make it which results in an ever faster declining share to the rest of the people. Instead, we have refined new fuel and dumped it right into the top 1%’s hands and wonder why the engine is still sputtering?

One other issue I have with framing and the words used today: Under water.

People are not under water. They are not drowning in debt. On the contrary, people are dehydrating. They are starving for water. Do you know what the symptoms are of dehydration? You get thirsty and then urinate less to conserve water. (debt spending) Then you stop making tears and stop sweating. (can’t borrow) Eventually your muscles cramp, the heart palpitates and you get dizzy. (close to bankruptcy, voting against your interest) Let it go long enough and you get confused, weak and your coping mechanisms fail. (Tea Party, etc) In the end, your systems fail and you die. (recession)

People are dehydrating and Washington is doing nothing about it because they believe it is drowning.  They are throwing out life boats to people in a desert.  That is the chart Ken linked to.

What a Liquidity Trap Looks Like in Pictures

I want to follow up a little on my discussion of the liquidity trap that we are have been in. Brad Delong has an excellent post today called “Four Years After the Wakeup Call”.  In it he shows some graphs which illustrate very well our the liquidity trap.

Delong first serves us two graphs on the Federal Funds rate since early 2007:

The daily gyrations of the usually-placid Federal Funds market starting in late 2007 told us all that banks were really worried that other banks had jumped the shark and turned themselves insolvent.

FRED Graph  St Louis Fed 7


The Federal Funds rate is the interest rate that banks pay to each other when they borrow reserves from each other.  Despite the name, the rate isn’t set by The Fed. It’s set by market supply-and-demand.  It’s a large and brisk market.  When the Fed Funds rate is high (or at least rising), we can infer that banks need and are desperate for reserves, typically because they have profitable opportunities to make loans based on those reserves. When The Fed Funds rate is low and/or dropping, it means that a lot of banks have excess cash on their hands and don’t see any useful or profitable ways to use that money. In other words, a low Fed Funds rate means banks are willing to lend their reserves to other banks because it’s better than nothing and they don’t see any good ways to loan out the money. At the same time, a low rate also shows that few banks are interested in borrowing – again because they don’t see much useful to do with it.  While The Federal Reserve doesn’t set the funds rate, it does set the interest rate for the alternative: direct borrowing from The Fed.

What we see from the first graph is that things were cruising along in early 2007 and then mid- to late 2007 (August to be exact), the rate starts dropping.  We’re moving toward a recession.  Banks are finding it harder to make good loans so they don’t want to borrow more reserves.  Banks start hoarding their cash and assets.  So instead of balance sheets that are full of loans, bonds, and securities, the banks decide they want/need more cash.  Their reserves grow in order to provide a cushion for what was then being seen as the inevitable losses on mortgages and mortgage securities.  Things appear to stablize and then in Sept 2008 comes the Lehman moment.  Fed Funds rate goes virtually to zero.  It’s been stuck there ever since.  Banks have plenty of reserves. They have the cash to lend.  There’s no willingness to lend (banks don’t see many credit-worthy borrowers) and there’s little interest or demand to borrow.

The Federal Reserve has responded during the same period by creating new base money like crazy.  [NOTE: Contrary to the fears of the inflation-fearful crowd, it’s not really “money” until it’s in circulation with the public. It’s only bank reserves – the monetary base.  It creates the ability to create money for the public, but that would necessitate having a bank lend it first. ]  Again Delong shows up graphically just how The Fed has been willing to create new monetary base:

And while the Federal Reserve has taken the monetary base to previously-unimaginable levels–up from $900 billion to $1.7 trillion in late 2008, up to $2 trillion in let 209, and up to $2.7 trillion in early 2011–it has never adopted Milton Friedman’s recommended policy that it start buying bonds for cash and keep buying bonds for cash until nominal spending is on the path that the Federal Reserve wants it to be on:

FRED Graph  St Louis Fed 5

We only need one more graph: GDP.  More precisely a comparison of GDP to an estimate of what GDP could be if we were at full employment and operating at our long-term trend.  Again Delong:

And so right now nominal GDP is $15 trillion/year when it ought to be $16.7 trillion/year:

FRED Graph  St Louis Fed 6

I’ll save inserting the employment graph here.  I’m sure you all know what it looks like. Same story.

And that story is that we had signs of trouble 4 years ago.  Three years ago things went really into the tank.  The economy seriously declined until mid-2009. Ever since then, it’s struggled to hold on.  There really isn’t any recovery.  It’s just going sideways.  We have, in effect, taken a huge chunk of the economy, a huge number of workers, put them on the sideline and said “we’re not interested in you participatin anymore.  We don’t want or need your contribution. We’re happy being smaller”.

So we’ve had monetary stimulus efforts, we’ve had low interest rates, we’ve had the central bank create base money.  There’s plenty of cash out there.  But it’s all in the banks. It’s in deposit accounts. It’s in reserves.  It’s not working. It’s not being used to buy things. It’s not being used for consumption or investment. It’s just sitting around impotent.  That’s a liquidity trap.

Mainstream economic theory, the stuff called “New Classical” or “New Keynesian” (never confuse “New Keynesian” as being “Keynesian”), says keeping interest rates this low for this long would /should fix everything by now.  For over 30 years now, the dominant, orthodox view in the academic and professional world of economists has been that monetary policy exercised by a wise central bank can fix all.  Any weakness in the economy can be solved via lowering interest rates and having the central bank create new bank reserves.  These “modern” theories told us that the concept of a “liquidity trap” was nonsense, a relic of some past era and/or the invention of some crank called Keynes.  These theories claimed that everybody was perfectly rational, all markets (particularly financial markets) were efficient, and uncertainty/risk about the future was unimportant.  They were wrong. We are left with the ideas of the mid-20th century, the stuff that we were told to forget about.  Again Delong:

Four years ago nearly all mainstream economists would have said that, even though the situation appeared serious, by now the economy would be back to normal. …

Very few of us thought that it would be long and nasty…

And as it turned out to be long and nasty, recent economic theories of macroeconomics have fallen like tropical rain forests. The–already implausible–claims that downturns had real causes? Fallen. The claim that downturns lasted only as long as workers misperceived their real wage? Fallen. The claim that the labor market cleared in a small number of years? Fallen. Those of us who believed that the long run came soon, that the cause of downturns was transitory price-level misperceptions, or that downturns had real causes need now to be looking for new jobs, or at least new theories.

And we are left with the live macroeconomic theories being those of the 1960s, at the latest. This is embarrassing for those of us who want to belong to a profession that is a progressive science, rather than an analogue of medieval barbering.

So what would the economic theories of the 1960s and before tell us to do?

  • Milton Friedman: monetary expansion, and more monetary expansion–quantitative easing as deep and as broad as necessary to get nominal GDP back to its trend.
  • John Maynard Keynes (or at least one of the moods of Keynes): have the government borrow and buy stuff, and keep buying stuff until real economic activity is back to some normal trend value.
  • Jacob Viner: Why choose? Do both! Print lots of money and have the government use it to buy stuff and hire people.

The odd thing is that none of those three recommended policies–all of which are sponsored by economists with the purest of purebred pedigrees–have been followed.

It’s time to do two things.  At the policy level we need to go back and try the policies that we understood back in the 50’s and 60’s (economy did pretty well back then, BTW).  Some serious, bold attempts at effective government spending would be nice instead of the weak, too-small, too-timid, niggling efforts dominated by tax cuts we’ve been doing.  And even on the monetary front, it would be more useful to do as Friedman suggested: actually have The Fed keep buying bonds for cash (real circulating money instead of just bank reserves) and keep it up until people start spending it.

On the economics side, we need to get past the perfect rationality and rational expectations stuff (and it’s absurd mathematics) that has dominated the profession.  It would be a good idea to take a more serious look at the heterodox ideas and theories that actually did foresee the crash, the ones based upon realistic models of human behavior and models instead of the perfectly rational, knows-the-future home economicus of the New Classical and New Keynesian models.  We need to seriously look at ideas of Modern Monetary Theorists (MMT), Minsky, the Post-Keynesians, and the behavioral economists.



But What About National Debt-to-GDP Ratio? Not a Problem, Really

In the comments to my post on the extraordinarily weak 2nd qtr 2011 GDP numbers a reader asks for my thoughts about debt-to-GDP ratio and “how can we afford more stimulus”?  Since my response will be a little long and others might be interested, I’ll post it here.

Reader AZLeader asks:

Here are some other GDP indicators I’d value your comments on…

Government spending now is somewhere around 28% of GDP, well above the 60 year average of 18.6% or so.

Spending as a % of GDP is indeed up, but it’s not primarily as a result of discretionary spending going up.  In other words, the so-called Stimulus spending bill didn’t do the damage.  The ratio is up in large part because the denominator (GDP) shrunk.  We lost a huge chunk of GDP.  That has a double effect on the ratio.  When the economy goes into recession and doesn’t recover it reduces the denominator by a big chunk.  But a recession also automatically increases government spending through automatic stabilizers.  Spending on unemployment compensation, welfare, Medicaid, SS disability claims, etc. automatically increases, thus increasing the numerator as well.

Krugman shows this graph from the St.Louis Fed using non-partisan Congressional Budget Office data that compares the changes in spending to changes in the potential GDP over 60+ years.  Potential GDP is the GDP that would be produced if we were at full employment.  It indicates our capacity to produce if we choose to put all our resources (labor) to work.  Any value that’s above 1.0 indicates that spending is rising faster than potential GDP. A value less than 1.0 indicates that spending is might be increasing in total dollars, but it’s increasing less than what the potential GDP is.  When the value is less than 1.0 it means that government spending is having a contractionary effect on the economy. As you can see, the issue in the last few years is that despite the increase in dollars of spending, it’s been peanuts compared to the damage done by the banks’ financial crisis and the ensuing recession with high unemployment.  This part of the reason why I’ve (and a lot  of others) have said the stimulus program was too little and too short.

Government deficit spending last year was about 10.9% of GDP, way over the sustainable comfort level of 2.6%.

There’s two issues here.  First, There’s nothing that says 2.6% deficit as % of actual GDP is “sustainable” and greater than that isn’t.  “Sustainable” in the sense that we can operate at that level indefinitely might be less than 2.6% or it might be greater than 2.6%.  For private sector entities (you,me, households, corporations, state governments) there’s a real meaning to “sustainable”.  But that’s because ultimately our spending ability is limited by the combination of our earning and borrowing ability.  Borrow too much and eventually lenders say “I don’t think you can pay it back, so pay higher interest rates, the debt begins to spiral up, etc.”.  But for a sovereign national government that creates it’s own currency, borrows using bonds denominated in that currency, and doesn’t strap itself to some fixed exchange rate system (like gold standard), there is no financial limit to the borrowing.  All of the nations that are having debt crises now (or in the past) have either strapped themselves to somebody else’s currency (Greece & Ireland with the Euro, Argentina in 2000 with the dollar) OR they borrowed their money in somebody else’s currency (less developed countries borrow in $ not their own currencies) OR they have  a fixed exchange rate (under the old gold standard 80 years ago).

What matters for “sustainability” is the ability of the economy to produce.  Does it have the  real resources to produce what the government is willing to spend on?  In this sense we see that even a 1-2% deficit-to-GDP ratio might be too high if we were at full employment and had no excess resources.  But the U.S. today has more than 10% of it’s labor force (even more since many would be workers aren’t looking) sitting on it’s hands doing nothing.

Another way of looking at the sustainability and desirability of deficit spending is to compare the interest rate the government has to pay to borrow now vs. the long-term growth rate of the economy.  If interest rates on government bonds were in the 6-8% range or higher (like in Greece and Italy), then large deficit spending might not be sustainable. But the U.S. is borrowing at near record low interest rates, less than 1% for a year.   Borrow at low rates, spend to invest in those things that grow your economy and get paid back later in larger GDP.

That brings me to my second point on “sustainability”.  The budget, government spending, is dynamic.  What GDP is the greatest determinant of what the deficit actually ends up being.  The budget discussions in Washington about 10 year projections are usually static projections.  They assume they can change the spending amounts while keeping the projected path of GDP the same.  Doesn’t work that way.  Running a large deficit relative to GDP, the kind of stimulus I think we need, will raise the deficit-to-GDP number immediately, but the ratio will then automatically decline. Again it’s the automatic stabilizers mentioned earlier.  As people go back to work and unemployment declines, the GDP rises faster.  Those people also pay taxes, so government revenues increase.  Spending in the form of unemployment comp, welfare, disability payments, Medicaid, etc all drop as people go back to work.  The deficit automatically shrinks relative to GDP.  This was how Clinton managed to produce a narrow government surplus at the end of this second term.  He eliminated the deficit completely.  It wasn’t by cutting spending. It was because the economy grew enough to reach full employment.

Government debt is just under 100% of GDP, the highest level in our economy that we’ve seen since WWII where it briefly spiked well above that.

Yeah, so what? Japan’s debt is around 200% of GDP and has been for over a decade.  Government debt is not like private debt.  It doesn’t have to be paid off. Government bonds are really just like government issued paper currency that pays interest.  This is why banks and investors love government bonds.  It’s a way to hold large amounts of cash and still earn interest.  A growing economy also needs a growing money supply and a growing supply of government bonds.  In the early part of this past decade (I forget the year), Australia was running a surplus for a few years.  It was paying down it’s national debt.  The bankers went to the Australian Treasury and the Australian central bank and asked the government to borrow and issue bonds anyway because they needed a larger volume of bonds in existence in order to run the banks.

Through “Intergovernmental Holdings” the U.S. government owns about 1/3rd of its own debt.

Yes.  $4.6 trillion, approximately 1/3,  of the $14.3 trillion total US government debt is “owned” by various other parts of the government.  The biggest chunk is the Social Security trust fund, $2.7 trillion.  The rest is in various other government “trust funds” such as Railroad employees retirement fund, government employees pension plans, highway building trust fund (paid by gas taxes), etc.  These funds reflect special taxes or fees that have been collected that are by law dedicated to a particular purpose, but the government hasn’t spent the money on that purpose  yet.  The accumulation of money in these funds (think of them as pre-payments of special taxes) must by law then be “invested” in the safest interest bearing assets available, which happen to be U.S. government bonds.  Let’s take a brief look at one of these funds: the Social Security trust fund.  The way SS works, dedicated SS payroll taxes are collected each month to pay for this month’s benefits.  (FICA taxes).  Obviously we want benefits to be relatively constant month-by-month.  Grandma wants to know just how much her check will be next month.  But the payroll taxes collected each month vary greatly. So, by the original law, SS Admin was supposed to make sure it always had enough liquid cash on hand to pay 1 year’s anticipated benefits.  This is the trust fund.  In the 1980’s the trust fund was too low – nearly depleted because benefits had been increased.  So payroll taxes were increased.  When the trust fund had fully recovered (circa 1991), the decision was made to continue to collect extra payroll taxes from workers in the 1990’s and early 2000’s in anticipation of the baby boom.  The current $2.7 trillion trust fund represents way more than the law said was necessary.  It represents the baby boomers having already pre-paid their own retirements.

These intra-governmental bonds cannot be traded on the public market, but they are regular debt obligations of the Treasury nonetheless.  To not pay these bonds is to renege on previous promises that people have relied upon.  It also might not be legal, although that is outside my experise.

In addition to the $4.3 intragovernmental holdings, there’s $1.6 trillion in government bonds held by The Federal Reserve.  These are ordinary bonds that The Fed bought from banks (that’s where banks get reserves).  Any interest paid on these bonds goes to The Fed who then sends it back to the Treasury as Fed profits.  This amount could easily be reduced by maybe 1/2 without consequences.

Given these constraints, where can we get the money to fund spending programs like the “stimulus” to create jobs and recover the economy?

As I attempted to describe above, it’s a fallacy to think of the government as having a financial constraint on it’s resources.  Government (again, a sovereign, fiat money, floating exchange rate, government that borrows in it’s own currency) faces no financial constraint.  Government is not like a household no matter how often misguided politicians say it.  You, I, households, firms, corporations, and state and local governments must obtain cash from either income or borrowing before we spend it.  Government does not face that constraint.  Government defines and creates the reserves that can become our spending money.  It has a monopoly on the creation of money.  And money today can be created as fast a somebody at the central bank can type (although we may not want to create it that fast).

Let’s consider what actually happens when the government spends.  The Treasury writes a check and sends it to a contractor, or SS beneficiary, or someone.  That check is drawn on an account at The Fed Reserve bank.  Let’s suppose you get the check.  You got income from the government. You take the check to your bank, let’s say it’s Chase.  You deposit it in your checking account.  You go out and spend the money by using your debit card to buy dinner, thereby helping to create a job and employ a waiter and kitchen staff.  But what happens at the bank?  Chase takes your check and sends it to The Federal Reserve. The Federal Reserve takes the government check and credits Chase’s account at The Fed.  This creates bank reserves.  The Federal Reserve has no limit on how much bank reserves they can create.  They can create all they want.  In the barbarous old days of the gold standard (before 1971), The Fed would have had to make sure it had enough gold on hand before issuing any reserves.  No such limit now.

So why doesn’t the government just spend endlessly with no limit?  Well, there’s no financial constraint on the government spending, but there’s a real resource constraint.  When the government attempts to increase deficit spending it is in effect placing orders for work to be done, things to be produced, and people to be employed (you do the same thing when you spend).  As long as there are unemployed resources to be put to work, the deficit spending is OK.  It stimulates more activity.  But if there are no idle resources then increased deficit spending will produce inflation because the government would be bidding against everybody else for resources.  At nearly 10% unemployment we have plenty of idle resources and that’s why there’s no threat of inflation despite the worries of those who don’t understand the gold standard ended 40 years ago.

There’s one other aspect of deficit spending that’s important.  This is not the result of theory, but rather is pure accounting.  I’ll just give a very brief mention of it here, but there’s a full tutorial here by Randall Wray.  A one page view of this idea is here.  Basically, government deficits are the mirror of the private sector.  There’s three “balances” that must add up to zero.  There’s the government spending vs. taxes balance, called the budget deficit.  There’s the question of whether the private sector (all households and firms together) are accumulating financial assets.  This is called “net private financial wealth”.  It’s the difference between what our private incomes each year and our private spending.  If we spend less than our income, then we are accumulating net financial assets, or in plain language, we’re putting money away in our bank accounts and investment accounts.  There’s a third balance which is the external capital account balance.  Basically it’s like the private net financial asset accumulation except it records how much foreigners are accumulating U.S. denominated financial assets.  If imports are greater than exports (trade deficit), then foreigners are collecting U.S. financial assets, typically government bonds.

Now there’s no way the private sector can create net any new financial assets. If I loan money to you, yes, I create a financial asset on my books.  But you’ve created an exactly offsetting private debt on your books.  In aggregate, the private sector cannot create new financial assets.  That’s because financial assets are things like money, currency, and bonds.  And they can only be  created by government. They can also be gotten from foreigners by selling more exports than imports, but that ain’t gonna happen anytime soon.  By accounting, these three balances must equal zero.  This means that when the government runs a deficit it creates net financial assets that the private sector can accumulate.  If the government creates a surplus.

In simple language, this means that, assuming we run a trade deficit, that a government deficit means the private sector can accumulate financial assets.  If the government runs a surplus, though, it means the private sector must go deeper into debt itself.  See the answer to question 1 here for another explanation. There’s a dramatic historical graph that beautifully illustrates this relationship over the last 60 years.  Unfortunately, I can’t put my hands (mouse, really) on it right now.  When I find it again I’ll update.  The point is that government surpluses, the kind that the Tea Party and many Republicans claim they want as being responsible, can only happen if the private sector as a whole goes deeper into debt.  It’s private debt that got us into the Great Recession/Financial Crisis, not public debt.  In fact, the Clinton surpluses were a small part of it because to create those Clinton surpluses the private sector had to go deeper into private debt – which we did. It was called mortgages, corporate debt, credit cards, student loans, etc.

A long response, but I hope it was worth it and helps.

Government Bonds are Just Like Government Money

Government debt is not like private debt.  Government debt, government bonds, are really just another form of the government-issued fiat money obligations – just like paper money.  There really is little difference between government bonds and that paper money in your pocket – except that the bonds pay interest and are harder to cash at 7-11.  Yves Smith at NakedCapitalism points out what I’ve mentioned before:

what is the functional difference for the federal government between Treasury securities and bank notes? Both are liabilities of the federal government. But liabilities of what? The only obligation they enforce on the government is the promise to repay with more paper (or electronic bank credits, if you will). For all intents and purposes, bank notes, reserve deposits, and Treasury securities are fungible: they are obligations to be repaid in the same fiat currency.

I’m looking at a five dollar bill right now. It says “Federal Reserve Note” across the top. It has an oversized picture of Abraham Lincoln in the middle. It also says “this note is legal tender for all debt, public and private” in the lower left, signed “Anna Escobedo Cabral, Treasurer of the United States.” On the back, I see “The United States of America” up top and “In God We Trust” underneath with a picture of the Lincoln Memorial in the middle, labelled “Lincoln Memorial” for those who don’t know what it is. But, I’m trying to figure out why Geithner and the gang couldn’t just reel off a bunch of these and some Jacksons and Benjamins and pay people?

Now I’m looking at a Canadian Twenty. It sure is colourful. It has a bunch of French on it and a picture of the Queen. But, other than that, it’s really no different than the American fiver. “Ce billet a cours legal/ This note is legal tender.”

I have some Euros and Mexican pesos too. But these central banks don’t say anything about their obligations. Very dubious! At least they’re colourful like the Canadian money.

How ‘bout a British tenner? Dickens on the front, and the Queen on the back (she’s everywhere). A-ha. Here’s what I’m looking for. It says “Bank of England. I promise to pay the bearer on demand the sum of ten pounds.”

I think that gets me to my point, actually. From the government’s perspective, there is no functional difference between any of its obligations like bank notes, electronic credits, or treasury bills and bonds. As the Ten pound note says, “I promise to pay the bearer on demand the sum of [fill in the blank sum][fill in the blank fiat currency].”

So, the U.S. government could legitimately stop issuing bonds altogether if it wanted to. When people complain about the admittedly enormous government debt, they don’t think of the mechanics of the issue. As I see it, in a fiat money environment, the first function of the Treasury bonds is to serve as a vehicle to add or subtract reserves in the system to help the Federal Reserve hit a target Fed Funds rate. The second is to give holders of government obligations a return on their investment. After all, bank notes or bank reserves don’t pay much if anything.

If you’ve following, then you realize two things.  First the government* can always pay off it’s bonds.  Second, there’s no budget constraint that forces the government to “borrow in order to spend”.  Instead, the government chooses to borrow (issue bonds) to meet any difference between spending and tax collections.  It’s a political and policy choice.  The government could spend by issuing credits to bank accounts (electronic checks) which would create bank reserves. Or the government could just issue new paper currency to pay for it’s spending.  Either way, it’s essentially the same:  the government issues a paper (or electronic) obligation to pay in the future.

So what’s the difference?  Well there is one key difference.  (no, it doesn’t have to do with inflation).  Money or bank reserves issued doesn’t pay interest.  So people have limits on how much they want to hold.  So they then spend it and the money goes into circulation as people buy, sell, and trade things.  The real economy grows because the medium of exchange is more plentiful.  What happens when bonds are issued instead?  The holders of bonds earn interest.  That makes them comfortable just sitting on the bonds and collecting interest from the government at no risk.  There’s no exchanges, no trading, no buying, no selling.  No economic activity.  The political preference for borrowing over issuing money/credits means a subsidy to a narrow class of people to take their wealth out of circulation.

Private Debt vs. Government Debt

The Great Recession of 2007-2009, which has been morphing into a Depression, has been different from most recessions of the post-World War II era.  It has been what economists call a “balance-sheet” recession.  Normally (at least since World War II), recessions were the result of the central bank (The Fed in the U.S.) raising interest rates because it thought the economy was growing too fast or that inflation was too high.  This time, though, the triggers were a financial crisis brought on by a banking and financial sector that gorged itself on risky debt: subprime mortgages, derivatives, and bizarre financial products bought with borrowed money.  The financial crisis and resulting recession then brought an end to the debt game for ordinary households.  For thirty years or so, ordinary households, middle class folks, have struggled with declining real incomes and real wages.  To maintain a middle class lifestyle, ordinary folks took on huge debts: mortgages, home equity loans, credit cards, and student loans.  As deflation and unemployment hit in 2008 and the housing price bubble burst in 2007, the debt became unbearable, driving many to bankruptcy, foreclosure, and to drastically reduced spending*.

With this backdrop, it’s no surprise that debt has become an emotionally-charged word laden with negative feelings for most people.  People who are struggling with too much debt naturally are averse to the idea of debt. People who aren’t struggling with too much debt are resentful of those who do owe because they blame the debt-burdened for the recession (strange that the lender never gets blamed).

Unfortunately, politicians and news media with a political agenda have tapped into these negative emotions about debt to push their agenda to end the modern social support services that government provides.  They have done it by drawing false parallels between households and the government. Politicians from both parties have spent most of this year (and last) agitated about government deficits and debt. Even President Obama has done this in his July 3 radio address.  But the government is not like a household. There are many reasons why financially, governments are not like households. In this context, I am speaking solely of sovereign, currency-issuing governments with floating exchange rates.  This means Greece, Ireland, Portugal, Italy and the other Eurozone countries are excluded.  I’m talking about the U.S., the U.K., Canada, Japan, Australia, Brazil, and others. There are many reasons why governments are not like households ranging from tax powers vs. wages to unlimited life. But I want to emphasize one in particular: governments are the sole monopoly issuer of their money.  Households cannot issue money, only governments can.

So what does this have to do with debt?  It means government debt is not like private debt. Government debt need never be paid off.  It can be rolled-over.  As bonds become due, they are replaced with new bonds. Households can’t always do that. Governments cannot be “foreclosed” or “repossessed”.  Households and their goods can be.  Households and private firms can go bankrupt and default.  Sovereign governments only default when they choose to do so.  Historically the only known instance of a sovereign, floating currency issuing government defaulting was Japan in WWII, but that was deliberate.  U.S. and British banks held much of the debt and they were at war.  Some Republicans (example: Ron Paul) have recently been suggesting the U.S. default, but it’s still possible that grown-ups will prevail.  Politicians and ideologically-driven economists and news media have whipped up a frenzy about government debt as being evil.  But it isn’t.  In fact, government debt is necessary to the functioning of a modern financial system. It provides a safe, interest-bearing financial asset.

So if government debt isn’t evil or bad for us, how should we think about it?  Government bonds are best thought of as currency that pays interest and can’t be used at the 7-11 store. So rather than thinking of government debt as just another form of debt like private mortgages, corporate debt, student loans, and credit cards, it’s better understood as just another form of money. It’s a holding pen for idle money.

Much is made in the media about the fact that many “foreigners” hold US government bonds.  Again, the media is trying to create a scary feeling by drawing a false analogy to private debt.  If you’re a homeowner, the bank who holds your mortgage has some power over you, particularly if you don’t make regular payments.  The media want us to feel like some how the “foreigners” have power over our government because they hold the debt.  But that’s false. The foreigners can’t repossess or foreclose on the U.S. government, regardless of whether the government makes payments or not.  Again, government debt is not like private debt.  Private debt is the result of lenders making loans at interest with the goal of making a profit. But government bonds that are owned by “foreigners” are primarily owned by foreign central banks and banks.  They are used as safe reserves, not for the primary purpose of making a profit.  US government bonds are the modern banking world’s substitute for gold.  Foreigners want US bonds because they want a safe, secure asset that earns more interest than stacks of idle paper currency.  It’s not because primarily for profit-making.  If they wanted profits, they would use the money to make loans. Instead they want security.  That’s why they accept interest rates in the 1-3% range.

When somebody tells you that government debt is bad and harmful and we must do everything we can to reduce debt, even if it means high unemployment, remember they have another agenda that they aren’t talking about. It’s scare tactics.

* remember that drastically reduced spending might appear to help make the payments on debts, it also means that somebody else loses their job because their employer isn’t making a sale.  That newly unemployed person now has debt problems too.

Debt Ceiling: Kabuki Theater of the Absurd

Tuesday evening the House of Representatives voted on whether to raise the so-called “debt ceiling”.  It was pure charade.  No, it’s worse. It’s kabuki theater of the absurd.  First off, the House Republican leadership knows it’s only for show.  The reality is that Congress will vote to raise the limit later this summer.  They have no choice.  The whole concept of the debt ceiling is absurd and likely unconstitutional. Let’s see the news itself, this taken from ABC News:

The House of Representatives rejected an increase to the statutory debt limit in a move chastised by Democrats as “a political charade,” “political cover” and “political theatre.”

The measure, which failed by a vote of 97-318 with seven members voting present, stated that “the Congress finds that the President’s budget proposal, Budget of the United States Government, Fiscal Year 2012, necessitates an increase in the statutory debt limit of $2,406,000,000,000,” and would have raised the debt limit to $16.7 trillion.

All 236 Republicans voted against the increase – joined by 82 Democrats. 97 Democrats voted yes for a debt limit increase, while 7 Democrats voted present.

The bill required a two-thirds majority to pass.

Why was it a charade? Because the Republican leadership designed it to be a fake.  This from Time mazazine’s website (bold emphasis is mine) just before the vote:

Not be a spoiler, but Tuesday evening’s House vote to increase the federal borrowing limit by $2.4 trillion without preconditional spending cuts will fail. It was designed that way by the Republican leadership: They used a procedural trick to require a 2/3 majority for passage and told every member of their caucus to vote against it. The idea, they say, was to prove to the world (and congressional Democrats) that raising the debt ceiling won’t happen without a package of accompanying spending cuts.

Mission accomplished: President Obama has been admitting as much for weeks and House Democratic Whip Steny Hoyer on Tuesday recommended that Democrats join Republicans in voting down the “clean” debt limit measure. “My advice to them would be not to play this political charade,” he said. Of course, the failed vote is the charade. Time to play spoiler again: Congress will raise the debt ceiling by the end of the summer. Tuesday’s failed vote only serves to provide political cover for members of Congress who will eventually back the incredibly unpopular increase in borrowing capacity.

Now supposedly Wall Street and the financial markets understand that Congress isn’t really serious about intentionally defaulting on U.S. bonds.  The New York Times in it’s report on the vote:

“Wall Street is in on the joke,” said R. Bruce Josten, executive vice president of the U.S. Chamber of Commerce.

So the whole point is so that members of Congress can claim on the campaign trail that they voted against the debt ceiling increase when in fact they are also going to vote for it later this summer.  Absurd.  Pure theater. It’s all political pretend.

Beyond the politics, though, the economics is even more absurd.  First, the concept of a “debt ceiling”, a law that saws the government cannot borrow more than say $x dollars is absurd.  How much the government needs (or chooses) to borrow is basically already decided by legislation already passed that goes by the name “budget”.  Congress voted a budget not two months ago that requires, under current rules, more borrowing.  Now Republicans are claiming they don’t want to borrow the money they already committed themselves to borrow.  Got that? So are you following so far?  The House Republican leadership schedules a vote that it knows must fail (that’s why the special 2/3 requirement).  Why? So it can tell one thing to voters on the campaign trail while letting Wall Street “in on the joke”.  We have the best government Wall Street can buy.

But it’s doubly worse than just the lies they’re presenting to voters.  It’s all over what should be a non-issue.  Normally, I don’t like analogies between government and a household because such analogies don’t usually hold up very well.  Government, unlike a household, is not inherently budget-constrained.  But let’s try a simple analogy anyway.  Suppose you put together a budget for your household.  You project or know that you are going to earn $1000 per month.  So income is $1000.  Then you decide that you need to spend $1500 per month in outlays.  You have no savings. You are going to have deficit of $500 per month.  No problem, you have a credit card.  You can borrow to finance the deficit*.  Let’s suppose your credit card account has no credit limit.  The bank is saying you can borrow as much as you like.  In fact, the bank right now is telling you that you are such a good credit risk that you only have to pay 3% interest rates.  Under this scenario there’s no problem, right?  You need the extra $500, you borrow it.  The credit card balance goes up.  But there’s no limit to how high it can go.  That would be the government’s ordinary, constitutionally-mandated budget making process.

But sometime ago Congress decided to add another wrinkle.  It passed a “debt ceiling” law.  Supposedly this is another law, that independent of whatever the budget says, will limit how much total debt the government can have outstanding at one time.  Using our analogy, this is like the head of your household saying that they refuse to borrow more than $x on the credit card, regardless of what they previously said was their budget.  So two months ago, Congress passed the budget with a deficit.  It told the government to buy lots of things and not to collect very much taxes.  Now Congress wants to say they won’t pay.  Huh?  In the private world, this is called an unnecessary, voluntary default.

Yes, that’s what this vote says.  The Republican leadership has just told the world that they actually want the U.S. to default on bonds now!  There’s no economic reason why we need to default.  The financial markets are saying they actually want to lend money to the U.S. at record low interest rates.  The financial markets have long been saying they have no fears about the ability of the U.S. to pay in the future.  No matter. The House Republicans want to default just for the heck of it.  Well, actually it’s not for the heck of it.  They are holding the entire U.S. budget hostage, including payments to seniors, soldiers, and Medicare, because they want to change the future of Medicare and Social Security.  They want to end to programs and privatize everything for the benefit of Wall Street.  Such an agenda is hugely unpopular, so the Republicans can’t do it directly.  Instead they have to create a fake crisis about the public debt, hold a fake vote, and threaten national insolvency to get their way in cutting Medicare and Social Security.

*The whole issue is even more absurd when we consider how my analogy breaks down.  The analogy breaks down because the government doesn’t have to borrow to finance a deficit – it can just spend the money by creating new “high-powered money” which are also called bank reserves.  When the government spends, it just writes a check off the Federal Reserve bank.  It doesn’t have to have “money” in the checking account first.  When The Fed “cashes” the check, it pays your commercial bank with “bank reserves”.  Bank reserves aren’t really “money” in the public’s hands yet, but they can be thought of as “potential money”.  Unlike the primitive days of a century ago, there’s no artificial limit on how much can be spent.  There’s no gold standard.  (that’s a good thing!).

I do believe this is all theater of the absurb.  But it’s dangerous theater. I still believe that when the time comes this summer, Wall Street will call the political leaders and tell them enough’s enough, raise the limit and avoid default.  A default is much too dangerous to contemplate.  A default by the U.S. could bring economic disaster globally.  There’s always the possibility that these folks in Washington dig in their heels and let their egos get the best of them.  They don’t understand what they’re playing with, but that’s never stopped them before.
In the meantime, we’re treated to the spectacle of House Republicans claiming they would prefer the U.S. default now because they’re afraid that without big emergency spending cuts the government will end up defaulting at some point in the future.  Default now to avoid default in the future.  Yeah, I call that absurd.

Krugman Is Still Wrong About MMT – and with it still wrong on deficit

On Friday Paul Krugman posted the first of what has become 2-3 posts on his blog wherein he claims that MMT is “just wrong”.  As I noted Friday here, I commented on his blog to point out how his post was deceptive and misrepresented MMT.  I was not alone.  Well over 100 people have taken him task in his comments section for not having done his homework on MMT.

For those that want a more detailed refutation of the nonsense Krugman published, here’s a few links that have come up the last few days:

Bill Mitchell at Billyblog My favorite quote here:

Poor scholarship also involves not learning from your errors. You have often rightly accused the main body of our profession of having their heads in the sand (see How Did Economists Get It So Wrong?) and being inflexible in responding to the crisis.

Yet, you seem to keep wheeling the same errors of reasoning out yourself.

Scott Fulwiller writing at NakedCapitalism

The Daily Kos made three posts:

Paul Takes Another Swipe at MMT

Krugman Misleads His Readers – AGAIN!

The lesson, kids, is that even Nobel prize winners need to keep doing their homework.  If you are going to criticize some ideas, it is very important to actually read the stuff first.