4.2 Government debt, sound finances and 'dysfunctional finance'
/84/ MMT is not too explicit on why it deems sector balances to be of particular importance to its theory. Easily discernible, though, is MMT's stance that government debt should not be seen as a problem but as a benign option of 'functional finance', i.e. Lerner-style intensification of government deficit spending, accompanied by an explicit contempt for sound public finances. Government – i.e. government and central bank, and banks as intermediary deputy government – are called on to freely create what government wants to spend. Government is thought not to have to bother about the soundness of public finances in the same way that companies and individuals have to. According to Mosler:
'Today's fiat currency system has no such restrictions. The concept of a financial limit to the level of untaxed federal spending (money creation/deficit spending) is erroneous.' This 'is to say that the full range of fiscal policy options should be considered and evaluated based on their economic impacts rather than imaginary financial restraints'.[1]
Or, as Wray puts it: 'For a sovereign nation, 'affordability' is not an issue; it spends by crediting bank accounts with its own IOUs, something it can never run out of'.
That modern fiat money can freely be created out of thin air is self-evident and does not need to be accompanied by fanfare. It is now also understood by most people that fiat money is an achievement compared to the limitations of metallism. In MMT's message, though, this sounds like an unheard-of promise, /84/ while in reality it also represents a big problem: the quantity problem of making sure that neither government nor banks throw around too much money, or too little at times.
/85/ As discussed in 2.7, banks tend to get over-exposed in particular to rallying financial markets, real estate bonanzas and, most importantly, sovereign debt. Banks get over-exposed to sovereign debt because normally government is the best debtor, since it disposes of the largest cash flow, which allows for a steady flow of interest payments. At some point, however, government and banks, i.e. debtor and creditor, cross critical thresholds. This is not an orthodox prejudice but sad practice and experience.
Inflation and currency depreciation will set in; or a new round of asset inflation will lure investors big and small into the next financial crisis triggered by final over-investment and over-indebtedness; both developments will create political unrest; elite cooperation will become brittle, etc. Banks and other creditors will then have long begun to shy away from carrying on; as a result, the system breaks down or enters a stagnant stage of delayed insolvency characterised by defaults and asset write-downs, stagnant or suboptimal growth, heightened unemployment and shrinking purchasing power throughout most social classes. No nation can escape that sort of fate if it gets too deeply entangled in unsound finances. Not even direct central-bank funding of government budgets will then bail out a nation. Money is no remedy in itself if the money supply has strayed too far from its anchor of real-economic productivity and competitiveness.
What MMT acknowledges is a possibility of consumer price inflation resulting from too much credit creation for government spending at a time.[3] But this is not discussed in detail, reflecting MMT's Lerner legacy of 'functional finance' which entails a lax attitude towards high-level government deficit spending and debt. As long as inflation keeps within one-digit levels it is not acknowledged as a problem.
The idea of maintaining high levels of budget deficit, government debt and foreign-account deficit is wishful thinking. An overdrawn bow will bounce back or break. Formally, netting out of public-sector debt and private-sector assets is an obvious truth, 'simple' and 'general' indeed, without specific meaning. /86/ It obscures two things. Firstly, if public-sector finances come under pressure, e.g. through declining creditor rating, the value of private-sector assets falls correspondingly rather than 'covering' what they are erroneously supposed to. Secondly, it makes a difference who is creditor of government debt and how the holdings of sovereign IOUs are distributed, and who thus benefits from the public debt and who doesn't – especially how much falls on monetary and financial institutions and how much on, say, the 'rest of nation'.
Since banks and other financial institutions hold the major part of government debt, government interest payments go to banks and other MFIs and do not add to central banks’ interest-borne seigniorage, which flows back to the treasury. This happens only to a minor extent, and to a somewhat greater extent with regard to public welfare trusts and pension funds in various countries. For the remaining and biggest part, tax receipts have to be spent on interest payments that feed a growing share of capital income of banks and funds, at the expense of the share of earned income. Moreover, the small part of government debt held by households is also distributed quite unequally. A growing share of interest payments, combined with political resistance to still higher taxation, then results in ever more public budgets becoming chronically underfinanced. When rating agencies start to think twice, and banks reassess the situation and become less willing to fund government deficits and debt rollovers (which tends to come suddenly after a period of overstretch), it becomes apparent that any highly indebted government has a problem.
Contrary to what MMT maintains, problems of government debt are basically no different from those of company and household debt. And what applies to government indebtedness also applies to overall national indebtedness. One problematic correlation is between government debt and income distribution. Governments run deficits and incur debt for funding welfare or military spending. But over time neither welfare nor the military are the real beneficiaries, but creditor banks, funds and wealthy private persons. This would even apply if the possession of government debentures were more fairly distributed. /87/ The reason is that any expenditure or revenue – earned income, taxes, as well as payments on principal and interest – have to be paid out of current proceeds (as indicated by GDP), or else through taking up still more debt. The higher the debt-to-GDP ratio gets, the bigger the share of income that has to be paid on principal and interest, to the detriment of earned income and government transfers.
Furthermore, high government debt is an important contributive factor to inflation and slowed-down real growth. Reinhardt/Rogoff found a strong correlation between government debt and inflation in emerging countries, but could not document such a link in advanced countries.[4] If they had investigated in asset price inflation and asset bubbles, they inevitably would have detected the strong correlation that exists between asset inflation and government debt, also private debt and gross national debt in general. They actually objectivised that link in their earlier study on eight centuries of financial folly.[5] It is wondrous how orthodox economists manage to overlook the close connection between constantly increasing debt and credit levels, and unavoidable debtor and banking crises.[6]
As to the link between government debt and growth, Reinhardt/Rogoff found a weak correlation for a debt-to-GDP ratio below 90 per cent, but a strong correlation above this threshold, where average growth rates drop from 3 per cent to -0,1 per cent. In emerging economies that threshold was found to be much lower and with broader variance.[7] In a time when almost all industrial countries have now passed a 90% debt-to-GDP ratio, this figure is of political relevance. No wonder the figure was disputed, most easily by questioning the data base.[8] The critics, however, did not dispute the existence of such a correlation. They actually confirmed it. They just found the effect to be less severe according to their data, causing average growth to decline from 3 to 2,2 per cent.
Critical thresholds are difficult to identify, yet undoubtedly they exist, similar to the limits of carrying capacity of ecosystems or the threshold to sickness in an organism. Beyond that sort of tipping point, chronic high indebtedness of one or more sectors undermines the economy in many respects. Flows of earnings can no longer meet the requirements of stocks of financial assets. /88/ Money is transactive, not productive by itself. A nation cannot live on income from financial capital – only a few privileged rich can. If there are disproportionally many rich people in one nation, this indicates the appropriation of wealth of the 'rest of the nation' as well as wealth of the foreign 'rest of world'.
There are reasons why deficit spending lost its shine around the 1980s: 'functional' finance did not deliver on its promise. Quite often, it even proved to be dysfunctional. Since its beginnings about a hundred years ago, the idea of additional government expenditure compensating for a lack of effective demand was justified on the grounds of occupying idle capacities. MMT continues that view.[9] Again, the reality is more complex. Business cycles are not just about more and less; there is structural change involved. Many economic problems have structural causes anyway. Structures in place, supplies and skills, may be redundant, obsolete, uncompetitive, representing mismatch, having low factor mobility, etc. Printing ever more money does not for the most part do away with structural mismatches and deficiencies unless there are detailed target policies to direct the money to uses which help to overcome mismatches and deficiencies. Otherwise well-intended government expenditure will turn out to be unproductive subsidies, in fact doing more harm than good. This is no supply-side ideology. It is about systemic necessities of real-economic market supply and demand complementing each other in a productive and competitive way. This, after all, is the very value base of all money.
Furthermore, there is not much discretion in public budgets since they tend to be highly predetermined by myriads of legally binding entitlements, contracts, claims and other liabilities. Public budgets are easy to expand, but tend to be rigid and thus hard to shrink. In addition, there are political problems rooted in the electoral cycle, clientelism and lobbyism. As a result, deficit spending is easily done in bad times, but trimming budgets and repaying public debt in good times never seems to work. In good times deficit spending may be less, in bad times it is higher, but times of no deficit spending hardly occur since the practice became routine. /89/ The reality has become one of deficit spending all the time. To NCT, credit creation regardless of functional limitations is nothing but bad housekeeping, whosoever's household it may be, and whatever the purposes on which excessive money supplies are spent. Sound finances matter always and everywhere.
Under fractional reserve banking, governments' monetary sovereignty is not a reality today but a goal of chartalist monetary reform. Even if it existed, having the full monetary prerogative and being able to freely create sovereign currency in no way entails that a government or central bank are not subject to restrictions and can spend as much as they like – just to the contrary. Monetary reform is about regaining quantity control of the money supply, which of course includes relative limitations to the quantity of money, and thus also limitations to the seigniorage available from additions to the stock of money.
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[1] Mosler 1995 14.
[2] Wray 2012 194.
[3] E.g. Wray 2012 112.
[4] Reinhardt/Rogoff 2010 pp.12.
[5] Reinhardt/Rogoff 2009.
[6] Schularick/Taylor 2009; Kindleberger 1993, 2000; Reinhardt/Rogoff 2009.
[7] Reinhardt/Rogoff 2010 pp.7.; 2009 pp.21.
[8] Herndon/Ash/Pollin 2013.
[9] Mosler 1995 14.