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The fundamental principles of modern monetary economics

- by Bill Mitchell

The following discussion outlines the macroeconomic principles underpinning modern monetary theory (sometimes referred to as Chartalism).

The modern monetary system is characterised by a floating exchange rate (so monetary policy is freed from the need to defend foreign exchange reserves) and the monopoly provision of fiat currency. The monopolist is the national government. Most countries now operate monetary systems that have these characteristics.

Under a fiat currency system, the monetary unit defined by the government has no intrinsic worth. It cannot be legally converted by government, for example, into gold as it was under the gold standard. The viability of the fiat currency is ensured by the fact that it is the only unit which is acceptable for payment of taxes and other financial demands of the government.

The analogy that mainstream macroeconomics draws between private household budgets and the national government budget is thus false. Households, the users of the currency, must finance their spending prior to the fact. However, government, as the issuer of the currency, must spend first (credit private bank accounts) before it can subsequently tax (debit private accounts). Government spending is the source of the funds the private sector requires to pay its taxes and to net save and is not inherently revenue constrained.

So statements such as “the federal government is spending taxpayers’ funds” are totally inapplicable to operational reality of our monetary system. Taxation acts to withdraw spending power from the private sector but does not provide any extra financial capacity for public spending. As a matter of national accounting, the federal government deficit (surplus) equals the non-government surplus (deficit). In aggregate, there can be no net savings of financial assets of the non-government sector without cumulative government deficit spending. The federal government via net spending (deficits) is the only entity that can provide the non-government sector with net financial assets (net savings) and thereby simultaneously accommodate any net desire to save and hence eliminate unemployment. Additionally, and contrary to mainstream economic rhetoric, the systematic pursuit of government budget surpluses is necessarily manifested as systematic declines in private sector savings.

We often read that the appropriate fiscal stance is to balance the federal budget over the business cycle. Some economists claim the goals should be to run a surplus on average over the cycle allowing for deficits in extreme downturns.

Both goals would be fiscally irresponsible in Australia’s situation where our current account is typically in deficit. If the government balanced the budget on average and the current account deficit was in deficit over the business cycle then the private domestic sector would on average be in deficit (dis-saving) over that cycle. The decreasing levels of net private savings financing the government surplus increasingly leverage the private sector. The deteriorating debt to income ratios which result will eventually see the system succumb to ongoing demand-draining fiscal drag through a slow-down in real activity. In other words, adopting a growth strategy that relies on increasingly leveraging the private sector is unsustainable.

The only way the private domestic sector can save if there is a current account deficit is for the government sector to run deficits up to the desired private saving. Government deficits “finance” private saving by ensuring that aggregate spending is sufficient to generate the level of output and income that will bring forth the private desired saving levels.

Unemployment occurs when net government spending is too low. As a matter of accounting, for aggregate output to be sold, total spending must equal total income (whether actual income generated in production is fully spent or not each period). Involuntary unemployment is idle labour unable to find a buyer at the current money wage. In the absence of government spending, unemployment arises when the private sector, in aggregate, desires to spend less of the monetary unit of account than it earns. Nominal (or real) wage cuts per se do not clear the labour market, unless they somehow eliminate the private sector desire to net save and increase spending. Thus, unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.

How large should the deficit be? To achieve full employment net government spending has to be equal to the non-government desire to net save to ensure there is no aggregate demand gap.

Unlike the mainstream rhetoric, insolvency is never an issue with deficits. The only danger with fiscal policy is inflation which would arise if the government pushed nominal spending growth above the real capacity of the economy to absorb it.

If governments are not revenue constrained why do they borrow? We have to differentiate voluntary constraints governments impose on themselves (which reflect ideological dispositions) from the underlying mechanics of the banking system in a fiat monetary system.

In terms of the latter, while the federal government is not financially constrained it still might issue debt to control its liquidity impacts on the private sector. Government spending and purchases of government bonds by the central bank add liquidity, while taxation and sales of government securities drain private liquidity. These transactions influence the cash position of the system on a daily basis and on any one day they can result in a system surplus (deficit) due to the outflow of funds from the official sector being above (below) the funds inflow to the official sector. The system cash position has crucial implications for the central bank, which targets the level of short-term interest rates as its monetary policy position.

Budget deficits result in system-wide surpluses (excess bank reserves). Competition between the commercial banks to create better earning opportunities on the surplus reserves then puts downward pressure on the cash rate (as they try to off-load the excess reserves in the overnight interbank market). So budget deficits actually put downward pressure on short-term interest rates which is contrary to all the claims made by mainstream economics.

If the central bank desires to maintain the current positive target cash rate then it must drain this surplus liquidity by selling government debt. In other words, government debt functions as interest rate support via the maintenance of desired reserve levels in the commercial banking system and not as a source of funds to finance government spending.

However, the central bank could equally just pay the commercial banks the target rate of interest on all overnight reserves which would achieve the same end without the need to issue debt. So there is no intrinsic reason for a sovereign government to borrow to “finance” its net spending.

The reality is, however, that the neo-liberal era has forced the governments to adopt voluntary constraints on its fiscal activity which are tantamount to those that operated during the gold standard period. So the federal government now issues debt to the private markets via an auction system $-for-$ with net government spending (deficits). This allegedly imposes “fiscal discipline” on the government (it is totally unnecessary from a financial perspective) because the rising debt becomes a political issue.

In conclusion, much of the deficit-debt hysteria that defines the current macroeconomic debate is based on false premises about the way the monetary system operates and the financial constraints on government spending.

Modern monetary theory provides a sound basis for understanding the intrinsic opportunities available to governments in a fiat monetary system and exposes most of the constraints that are imposed on the conduct of fiscal policy as being of an ideological origin.

This text was originally published on Bill Mitchell's blog: In the Spirit of Debate, and is republished here with the author's permission.

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