The Role of Government Deficits

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MMT 101

The MMT fundamentals, as explained
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Modern Money Systems
The Real Economy
Money, Government and Banking
The Role of Government Deficits
Full Employment along with Price Stability



In modern money systems of today (using a free floating non-convertible currency) the currencies have no intrinsic worth, but are instead tax-driven. As a currency driven by tax-obligation is introduced, people will seek to work to obtain the currency in order to pay their taxes. In a sense therefore, the introduction of a tax-driven currency creates unemployment, i.e people seeking paid work. The government can thereby employ unemployed resources to implement its programs.

In the analysis, it is useful to divide the economy into the government sector and the non-goverment sector (of which the latter can be divided into the private domestic sector and the foreign sector). It is obvious that not all sectors can simultaneously have an net inflow of financial assets. If the government runs a surplus, that means that the non-government runs a deficit and vice versa.

The non-government sector typically has some desire (intention) to net save, i.e increase its hoards of net financial assets, by holding on to some of its income. This is the norm in a growing economy.

This generates a demand leakage that causes unemployment -- unless an injection of financial assets into the private domestic sector offsets the leakage. Government deficits can create the needed inflow. MMT asserts that in a growing economy, persistent government deficits are the theoretical and practical norm, and that there is nothing inherently wrong with government deficits.

The leakage can also be offset using private debt expansion. This is however not a sustainable growth path, as debtors will eventually reach critically high debt-to-income-ratios, so that they will not be able to service their debt.

Tax-driven Money and Unemployment

MMT describes the workings of modern money systems – floating exchange rate fiat[1] currency systems. Such currencies has no intrinsic worth.

Orthodox economic theory describes money as something that spontaneously emerges from a barter economy as a medium of exchange from the attempts of enterprising individuals to minimize the transaction costs. (Interestingly however, anthropological and historical research indicates that this has never happened -- there is no empirical evidence of one single case of this ever having occurred.[2][3]) Money is thereby viewed much like another barter good, deriving its value from its metallic content, although with lubricating effects on the barter economy. [4]

MMT inherits its view on money from Chartalism, holding that money (broadly speaking) is a unit of account, designated by a public authority for the codification of social debt obligations.[4] Historically, such units were originally designated by public bodies like ancient penal systems, palaces, temples, rulers, governors and nation-states, to keep track of liabilities.[4] We see this history reflected in the words for monetary debt, liabilities and redemption being associated with religious, criminal or moral guilt in many languages.

In modern day, the main form of obligations driving the value of currency is taxes, fees and fines imposed on a population by a governing regime. People must obtain the currency in order to extinguish their tax liabilities. Logically, these obligations thereby creates a demand for the currency of issue. On an abstract level of first principles, the fiat currencies of today are thus tax-driven -- they get their value from taxing.[5]

As taxes create a demand for the currency, people will have to offer to work to obtain it. Logically, therefore, the introduction of a tax-driven currency creates unemployment, i.e people seeking paid work. The government can then use the currency to employ resources at offer, purchasing real goods and services to facilitate the government's economic and social program.[5]

As the currency becomes widely accepted, people will have other reasons for demanding it other than as a means of extinguishing tax obligations. It becomes a store of value, subject to a propensity to be accumulated, net saved, by agents in the economy. It also becomes readily accepted means of exchange.

Sectoral Balances

In economic analysis it is useful to divide the economy into sectors, and analyze how flows between them affect economical activity. In a modern money system, the government plays a central role in the economy, since it is the currency issuer and the only entity that can spend without raising revenue. Further, its economical policies is subject to the democratic process, and should therefore be a focus of analysis. It is thus useful to divide the economy into the government sector and the non-government sector.

The non-government is often further divided into the domestic private sector and the foreign sector, to facilitate understanding of how foreign trade balances affect the economy. The domestic private sector is in turn divided into households and firms.

1. Government.
2. Non-government:
2.1 External sector.
2.2 Domestic Private sector:
2.2.1 Households.
2.2.2 Firms.
A common sectoral division in Sectoral Balances analysis.

The purpose of the analysis here is to understand what actions the government can and should take in order to achieve its goals (such as sustainable full employment and price stability) in the domestic private sector.

As a matter of simple accounting, the government's fiscal balance is the inverse of the non-government balance; a government deficit over a year corresponds to a non-government surplus, an increase in non-government's net financial assets.

In aggregate, there can be no accumulation (net savings) of financial assets in the non-government sector without the corresponding cumulative deficit spending from the government.

The government is the only entity that can provide the non-government with net financial assets.

For example, if the foreign sector balance nets at zero (i.e the foreign trade balance is zero), a government deficit corresponds to a net increase of financial assets of the domestic private sector. Similarly, assuming a government that spends at zero balance, a foreign sector deficit (i.e a current account surplus) corresponds to a surplus in the domestic private sector. In essence, as a matter of accounting, all sectors can not possibly simultaneously run a surplus. There can not be an inflow of the currency into all sectors – at least one must have an outflow, a negative balance.[6]

The economical responsibility of the government concerns the economy of the domestic private sector. MMT proposes that the ultimate goals should be full employment and price stability. The key is to adjust government spending (in terms of amplitude and focus) so that effective demand in the domestic private sector results in just these goals.

Private Sector Net Saving Desires

The non-government sector typically has some desire (or intention) to net save, i.e accumulate, increase its hoards of net financial assets, by holding on to some of its income. This is the norm in a growing economy. The domestic private propensity to net may be likely to be larger in countries with less social social security or retirement benefits, as experience from Japan suggests[7]. Propensity to save is likely also affected by the current level of net financial assets, income and other factors in the economical environment. Culture plays a role too. Saving propensities typically also differ between different income groups, as low income earners tend to net accumulate a lesser proportion of their income. A foreign trade deficit is a manifestation of that the rest of the world has a desire to net save the currency in question (this was discussed in the article The Real Economy).

As we have seen from the Sectoral Balances approach above, domestic net accumulation of financial assets (in the domestic currency) can only occur if either the government sector or the external sector runs a deficit.

As an example, historically the US private sector spends less than its income – it net saves. In the past, on average the private sector spent about 97 cents for every dollar of income and saved 3 cents. Historically, the US ran a balanced current account on average, imports were roughly equal to exports (although this has changed in recent years, so that today the US runs a huge current account deficit). If the foreign sector is balanced and the private sector runs a surplus, this means by identity that the government sector runs a deficit.

And, in fact, historically the government sector averaged a deficit of about 3 cents for every dollar of national income. If the foreign sector is balanced, there is no way for the domestic private sector to net save unless the government runs a deficit. Without a government deficit, there would be no net private saving.[8][9]

In standard national accounting terms, net saving during a time period is what has been booked as income, less taxes and less spending on consumption, and also subtracted with what has been spent on investment. The remainder, the actual net saving, is what is being accumulated. If we let H denote net saving in the domestic private sector, in standard national accounting terms we have by definition H = S - I, where I is investment and S is (gross) "Saving", defined as income less taxes and consumption: S = Y - T - C. Net saving of the domestic currency occurring in the foreign sector is M - X (imports less exports). By identity, the net saving in the domestic private and the external sectors must be offset by a corresponding government deficit: G - T (government spending less taxing). In total, we have: (S - I) + (M - X) = (G - T). This accounting identity can also be derived from the standard national accounting equations: GDP = C + G + I + (X - M) ; Y = C + S + T ; GDP = Y by substituting and rearranging terms.

Deficits is the Norm in a Growing Economy

There is nothing inherently wrong with government deficits. They do not necessarily "crowd out" private activity, they do not "burden" future generations, they can not lead to "financial ruin" of the government[10]:123. Persistent government deficits are in fact the expected norm in a growing economy[10]:97. They add to the net financial assets (currency and bonds) of the non-government sector and this accommodates for its desired net saving[10]:129.

The government must not "over-fund" the desire to net save, i.e deficit spend so that effective demand exceeds the potential for the economy to expand to meet it. This happens at some point when the economy approaches full capacity utilization and full employment, if the government continues deficit spending. Should that happen, demand side inflationary pressure will arise – a general continuous economy wide price level increase.

But if the budget deficit is calibrated correctly – which means that it matches the saving intentions of the foreign and private domestic sectors taken together – then it can be 10 per cent of GDP or 1 per cent of GDP forever without adding inflationary pressure. It is only when the budget deficit accelerates and pushes total spending in the economy beyond the real capacity limits that they become problematic. So continuous budget deficits forever are fine if that is what is needed to offset non-government savings intentions.[11]

There is nothing special in this regard about government deficits when compared to a deficit in the private domestic sector or an external surplus (a "foreign sector deficit"). These balances all add to aggregate demand. So to say that budget deficits are dangerous with respect to inflation – under certain situations – is saying nothing more than any nominal spending growth (that pushes aggregate demand beyond the real capacity limits) is dangerous.[11]

Unemployment is Caused by Inadequate Deficits

One agent increasing their holdings of net financial assets necessarily corresponds to reduction of other agents' net financial assets, unless the government reacts to offset the decreased spending. This is the famous and somewhat unintuitive "paradox of thrift". Total non-government net saving in the economy can not be increased by individual decisions to net save.

Furthermore, if increased net saving is attempted by agents in the economy, the outcome may instead be unemployment leading to decreased net saving in aggregate.

Consider a full employment scenario as a starting point, with a government runs a balanced budget (and no foreign sector). Whatever is spent by someone becomes income for someone else. If all agents in the private sector decides to re-spend all of their income every week and not hold on to any of it, the result is an aggregate demand that will sustain full employment. If there are agents spending even more (by running down their savings), aggregate demand increases. Producers can work overtime to increase output, or raise prices.

However, if agents instead decide to attempt to hold on to some of their income – i.e net save, increase their net financial assets, accumulate – the decreased spending will cause aggregate demand to decrease below the level of full employment. An output gap opens as business sales drop, inventories build up and involuntary unemployment rises. The result is called a "demand leakage". (A looming recession can further enforce this effect, with decreasing spending due to uncertainty about the future and desires to pay down debt, "de-leverage", to strengthen balance sheets).

Unemployment occurs when net government deficits (G - T) are too low to accommodate for non-government net saving desires.

Keynesians have used the term "demand-deficient unemployment". MMT states that the basis of the "deficiency" is inadequate government net spending, given the private spending decisions in force at any particular time[12]. Or, for a given level of government spending, another way to see it is: if there is unemployment, it is evidence the economy is over-taxed[13][14].

In essence, unemployment exists because the government budget deficit is too small.

Private Debt Expansion

Inadequate government deficit spending can be compensated by private debt expansion for a while. This works as follows. If some agents are net saving (or the government runs a surplus) some agents must necessarily run down wealth. They can either spend less, forcing the economy into a slow-down, or maintain spending levels by going into debt within the private sector, borrowing from banks or other financial institutions. The net saving is offset by "horizontal" money creation rather than "vertical" (concepts that were discussed in the article Money, Government and Banking). Thereby, spending can continue although private sector net financial assets are decreasing.

Credit growth occurring within the private sector can support a growing economy like this for a while. This typically involves households liquidating assets and going into debt. It is however not a sustainable growth path, as it replaces sustainable government deficit spending with unsustainable private deficit spending. Unlike a modern money government, private households and firms are ultimately financially constrained.

At some point, debt-to-income-ratios will reach unhealthy levels, making the financial system vulnerable to disturbances such as changes in asset prices or interest rates. If debt expansion increases further, there will come a point where incomes are simply not high enough to service the interest payments.

An example is the so called "Clinton surpluses" in the US at the end of the 1990's, when the government ran the biggest government sector surpluses in US history. Combined with the current account deficit, the surpluses forced the private domestic sector into deficit, i.e the net financial assets decreased. This created a demand leakage. To maintain lifestyle, households compensated for the "fiscal drag" by running down their wealth and going into private debt. The financial markets were being deregulated under the Greenspan era[15][16], and creditors obliged with easy credit. The expansion of private debt kept them afloat for a while, and drove continued GDP growth. Finally households had to stop spending and retrenched to de-leverage their balance sheets (pay down debt). The economy went into recession 2001 under the Bush presidency. The recession soon caused the government to go into deficit again via automatic stabilizers such as increased welfare payments and decreasing tax revenues, and the surpluses were wiped out.[17][8]

Before the Clinton surpluses, the US government has attempted to string together successive budget surpluses six times in its history, and on each occasion, the attempt was directly followed by a depression.[18]

Wage Cuts or Government Deficits?

A common argument is that unemployment is caused by too high and rigid wages, not by too small government deficits[19]. (This argument is related to the idea that the government should balance its budget.) The workers' wage demands are too high, it is suggested. To clear the labor market, the argument goes, it is wage cuts that is needed, not increased government deficits. If only wages could be made less rigid, downward wage adjustments could restore full employment, it is said. It would seem that with lower wage costs, firms could hire more workers.

Of course, in reality it turns out that downward wage adjustments is not a very smooth process. Workers may refuse to accept the lower wages unless they are certain that they might otherwise lose their jobs. They may disbelieve announcements from management that wage cuts are needed -- "has management really tried hard enough to reduce other costs?" An announcement that a discharge of workers is needed is more likely to be perceived as sincere. The reason is that cutting the work force will cut output. Under normal conditions this would reduce profits. Wage cuts on the other hand would increase profits. Therefore there is a potential for abuse with management suggesting wage cuts even when not needed. Further, wage cuts can affect worker morale which can have consequences for productivity. Strikes may emerge. The ablest workers may be most inclined to leave.[20]

But even if wages could be made more downwards flexible, there are other problems with the wage cut argument. Wage cuts for workers would imply lower income for workers, which would also result in lower spending from workers. Therefore firms could lose sales, thereby nullifying the effect from the lower wages on unemployment levels. Granted, the lower wage costs would increase profits for firms, so spending out of profits could compensate for the lost spending out of wages. Then again, as spending out of wages often is higher than spending out of profits, this effect may not occur, and the decreasing wages could indeed result in lower aggregate demand.[21]

But what if the lower wages was accompanied with lower prices? If firms can cut wage costs they should also be able to cut prices, wage cut proponents argue. Lower wages and prices would imply that the value of "money" is stronger. More goods, services and investment could be obtained for the same amount of money. This could restore consumption and investment propensities, so that any desires to net accumulate financial assets would ultimately disappear -- the decreasing prices would induce agents to spend all income. This could restore aggregate demand to a full employment level, it is suggested.

There are however theoretical concerns to this argument as well, and whether such an economy would work is uncertain. Classical deflationary traps could occur. Due to the increasing value of the currency during deflationary episodes, agents tend to desire to increase their hoarding of net financial assets instead of spending and investing all income. This would cause sales to drop, thereby adding further deflationary pressure, resulting in an unstable spiral. The result could be the economy grinding to a halt.[21]

Steven Fazzari[21] expands on this, noting that: lower prices increase the real burden of debt for households and firms, or, equivalently, lower prices reduce the nominal cash flows available to service debt. This problem will lead to lower expenditure as agents “tighten their belts” to remain solvent and as lenders impose stricter credit standards on a more indebted economy. Lower prices or inflation rates also distribute wealth away from debtors toward creditors, that is, away from spenders toward savers, likely reducing aggregate demand. Lower prices may lead to lower expected prices that encourage agents to postpone spending until prices fall further. Lower expected inflation rates will raise real interest rates, again choking off spending, especially on assets typically financed over long periods of time, such as capital investment and residential housing. These contractionary effects of lower prices and inflation rates could overwhelm any benefits obtained by increasing the real quantity of money.

MMT suggests that instead it is the government deficit that should be adjusted (upwards to meet increasing net saving desires, and downwards at times when non-government spending is increasing). This can be done in a way that neither adds deflationary nor inflationary pressure and also achieves full employment, by using the proposed Job Guarantee scheme.


  1. the term fiat derives from latin "let it be done", referring to that the money is established by government decree; see
  2. David Graeber: On the Invention of Money -- Notes on Sex, Adventure, Monomaniacal Sociopathy and the True Function of Economics --
  3. L. Randall Wray -- "Modern Money" -- Working Paper No. 252; The Jerome Levy Economics Institute
  4. 4.0 4.1 4.2 Pavlina R. Tcherneva - Chartalism and the tax-driven approach to money
  5. 5.0 5.1 Bill Mitchell, What causes mass unemployment?
  6. This corresponds to foreign trade on a global level – not every country can have a trade surplus – net exports cancel out to zero.
  7. Yamada, Tetsuji (1990). "The effects of Japanese social security retirement benefits on personal saving and elderly labor force behavior". Japan and the World Economy 2 (4): 327-363. Retrieved 2011-05-28. 
  8. 8.0 8.1 L. Randall Wray. "Teaching the Fallacy of Composition: The Federal Budget Deficit". Retrieved 15 May 2011. 
  9. Stephanie Kelton. "What Happens When the Government Tightens its Belt?". Retrieved 31 May 2011. 
  10. 10.0 10.1 10.2 Wray, L. Randall (1998). Understanding Modern Money. Edward Elgar Publishing Limited. ISBN 978 1 84542 941 6. 
  11. 11.0 11.1 "To challenge something you have to represent it correctly". Retrieved 16 August 2011. 
  12. "A modern monetary theory lullaby". Retrieved 17 May 2011. 
  13. Warren Mosler, Full Employment and Price Stability,
  14. Mecpoc: Independent Conn. Senate Candidate Warren Mosler Signs Pledge to Vote Against Any Cuts in Social Security or Medicare,
  17. "Some myths about modern monetary theory and its developers". Retrieved 15 May 2011. 
  18. L. Randall Wray; The Federal Budget is NOT like a Household Budget: Here’s Why;
  19. Bill Mitchell's What Causes Mass Unemployment?
  20. Robert Schenk --
  21. 21.0 21.1 21.2 Steven Fazzari -- A Penny Saved May Not Be a Penny Earned: Thinking Hard About Saving and the Creation of Wealth;
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