MMT - Chap 2 - Spending by Issuer of Domestic Currency

In the Chapter the author presents general principles that are applicable to any issuer of a domestic currency.

What is a sovereign currency?

Majority of nations have adopted their own unique money of account. The government spending, as well as the taxes, fees and fines owed to the government, are denominated in the state money of account. When the court system assesses damages in civil cases, they too are denominated in the state money of account.

The national currency is often referred to as a “sovereign currency” that is, the currency issued by the sovereign government. Most sovereign governments retain a monopoly over the issuance of currency. If any other person tries to issue domestic currency, unless expressly permitted, they will be considered as counterfeiters and prosecuted.

What backs up the currency and why would anyone accept it?

Most of the sovereign currencies which are in existence, today are “fiat” currencies which means that they are backed by nothing. In the past, governments backed sovereign currencies with gold or other precious metals in order to get the private sector to accept the money issued by the government. However, in the current times, most currencies are backed by nothing. According to the author, even without any gold backing, the US dollar is in high demand all over the world. So, the contention that currency needs to be backed by precious metals in order to be acceptable is erroneous.

One explanation as to why anyone would accept a currency which is not backed by anything is the legal tender laws. Many governments have enacted laws that require citizens to accept the sovereign currency issued by the government to be accepted in discharge of domestic payments. Indeed, most currencies issued proclaim on their face that “This note is legal tender for all debts, public and private”. But legal tender laws alone are not sufficient in order for a currency to be accepted. There have been several examples in the past where governments could not create demand for their currencies despite passing legal tender laws. Their currencies were not accepted in private payments and sometimes even rejected in payments to the government. Further, there are also examples of countries where US Dollar circulates widely even though it is not a legal tender in those countries. Thus, legal tender laws alone cannot explain why a currency is accepted.

Another explanation as to why a particular currency is used in a transaction is its saleability in the market place. You will accept your national currency as a payment in a transaction because you know that even others will accept it if you what to make a payment. In other words, it is accepted because it is accepted. The author finds this explanation ludicrous. Hence, he has developed a more convincing argument.

Taxes drive money

The MMT explanation for acceptance of sovereign currency is taxes drive money. One of the important powers claimed by the sovereign government is the authority to levy and collect taxes. Tax obligations are levied in the national money of account and can only be satisfied by delivering the national money of account. Thus, people will demand the national currency because it can be used to discharge obligations to the government. Because everyone needs to pay taxes, everyone will need to hold some national currency in order to pay these taxes. Hence, the national currency will also be used in private transactions. You will accept the national currency as payment in a transaction because you know that even others will accept it, as everyone needs to pay taxes.

The government cannot easily force others to use its currency in private payments, but the government can force the use of currency to meet the tax obligations that it imposes. For this reason, neither reserves of precious metals nor legal tender laws are necessary to ensure acceptance of the government’s currency. All that is required is an imposition of tax liability to be paid in the government’s currency. Thus, taxes drive money.

What if the population refuses to accept the domestic currency?

From the previous section we know that taxes create demand for national currency. But the more important question is, how much currency will be accepted? Can the government issue more currency than required to discharge tax liability? If yes, how much more?

By Imposing and enforcing a tax liability government can ensure that at least those subject to taxes will demand the domestic currency, in an amount at least equal to the tax liability. In the developed nations, the population is willing to accept more domestic currency than what is needed for tax payments. Thus, the government will not have much problem in buying resources by issuing its own currency.

However, the situation can be very different in developing nations in which people do not trust the domestic currency and in fact prefer foreign currencies in private transactions. In this situation again the population will be will demand domestic currency to the extent it is required for payment of taxes. But the tax liability can be reduced by tax avoidance and evasion, which in turn will reduce the demand for domestic currency. Thus, the government may find it difficult to purchase output by making payment in its own currency.  

Where tax evasion is widespread and foreign currencies are used in private transaction, the government cannot simply increase its spending to try to move more resources to its public sector because it could just result in inflation. The government can acquire additional resources only by paying a higher price. And beyond some point government may not find anyone willing to supply resources in exchange for additional domestic currency. While the government does not need to tax before it can spend, its inability to impose and enforce tax liabilities will limit the number of resources the government can command.

This brings up an important point. The purpose of the monetary system (from the point of view of the currency issuer) is to move some resources to the government sector, and the purpose of the tax is to create a demand for currency that is used to accomplish that objective. The government needs a tax not to produce revenue but to create demand for the currency which then can be used to acquire labour, resources, and output. Most people think the purpose of a tax is to raise revenue so the government can afford to spend. The difference is subtle but the implication is important. The government cannot run out of the “wherewithal” to spend. It can, however, run out of public willingness to sell more labour, resources and output for currency – at least at a fixed price.

“Sustainability conditions” for government deficits

James Galbraith laid out the typical model used to evaluate the sustainability of deficit spending. The key formula is:

Δd = –s + d * [ (r – g)/(1 + g) ]

d is the starting ratio of debt to GDP, s is the “primary surplus” or budget surplus after deducting net interest payments (as shares of GDP), r is the real interest rate, * means to multiply, and g is the real rate of GDP growth.

The key idea is that so long as the interest rate (r) is above the growth rate (g), the debt ratio is going to grow. To be clear, a persistent deficit does not imply a growing debt ratio – that would depend on the relation between r (the interest rate) and g (the growth rate). Galbraith shows that even a persistent (and “high”) primary deficit is sustainable if the interest rate is low enough, because the debt ratio will eventually stop growing.

Here are some possible consequences of a persistent deficit that grows fast enough to imply rising interest payments and debt ratios:

1) Inflation: this tends to increase tax revenues so that they grow faster than government spending, thus lowering deficits. (Many, including Galbraith, would point to the tendency to generate “negative” real interest rates.) In other words, the (nominal) growth rate will rise above the interest rate, and reverse the dynamics so that the deficit ratio declines and the debt ratio stops growing.

2) Austerity: government can try to adjust its fiscal stance (increasing taxes and reducing spending to lower its deficit). Of course, it takes “two to tango” – raising tax rates might not change the government’s balance, as it could lower growth rates, and thereby actually increase the rate of growth of the debt ratio. Raising tax rates will reduce deficits only if the nongovernment sector reduces its surpluses (spending more to keep growth up).

3) The private sector will adjust its flows (spending and saving) in response to the government’s stance. If the government continually spends more than its income, it will be adding net wealth to the private sector, and its interest payments will add to private sector income. It is not plausible to believe that as the government’s debt ratio goes toward infinity (which means that the private sector’s net wealth ratio goes to infinity) there is no induced spending in the private sector. That is usually called the “wealth effect”. In other words, government debt is private wealth and as private wealth grows without limit this will eventually cause spending to rise relative to private sector income, reducing government deficits as tax revenues rise. In addition, private sector income includes government interest payments, so rising government interest payments on its debt could induce consumption. When all is said and done, the private sector will not be happy consuming less than its income flow –given its rising wealth – and will adjust its saving behaviour. If the private sector tries to reduce its surpluses, this can be done only by reducing the government sector’s deficits. It takes two to tango and the likely result is that tax revenues and consumption will rise, the government’s deficit will fall, and the private sector’s surplus will fall.

4) Government deficit spending and interest payments could increase the growth rate; it can be pushed above the interest rate. This changes the dynamics and can stop the growth of the debt ratio.

Ignoring the dynamics discussed in the previous points, to avoid an exploding debt ratio all the government needs to do is to lower the interest rate it pays below the economic growth rate. End of story; sustainability achieved.

Finally, even if the government’s debt ratio is high and unsustainable, the government cannot default on interest payment. Because the government can always print more money and make the interest payment. While perpetual private sector deficit spending is not sustainable, perpetual government sector deficits can be sustained.

“Sustainability” of current account ratios

US runs a persistent current account deficit offset by a positive capital account balance. Hence, a lot of people wonder whether this is sustainable.  To put it simply, there is a “flow” of Dollars abroad due to the current account deficit that is matched by the “flow” of Dollars back to the United States due to her capital account surplus. This is often (misleadingly) presented as US “borrowing” of Dollars to “pay for” her trade deficit. We could just as well put it this way: The United States imports more than it exports because the rest of the world wants to accumulate savings in Dollar-denominated assets.

But here’s the question: is a continuous current account deficit possible? A simple answer is yes, so long as “two want to tango”: if the rest of the world wants Dollar assets and Americans want the rest of the world’s exports (imported into the United States), this will continue.

Here is an interesting point: even though the United States is the “biggest debtor on earth”, the factor payments (interest and profit) flow in her favour (at least, so far). She pays extremely low-interest rates and profit rates to foreigners and earns much higher interest rates and profits on her holdings of foreign investments and debt. Why is that? Because the United States is the safest investment on earth. Anytime there is a financial crisis anywhere in the world, where do international investors run? To the US Dollar.

This could change, but probably not in your lifetime. There could come a time when another currency replaces the US Dollar as the international reserve currency. That might reduce external demand for Dollars, meaning that the rest of the world might want to reduce holdings of Dollars. They can do this gradually by reducing their net exports to the US. However, what some fear is that the transition would be much more sudden, as the rest of the world tries to unload Dollars quickly – trading them for some other currency. That is quite unlikely. Countries with huge Dollar holdings – like Japan and China – know that dumping Dollars would probably cause the Dollar to depreciate, meaning capital losses on their holdings. The transition to a new international reserve currency is far more likely to occur over decades, not over weeks or months or even years.

In short, we make no projection about continued US current account deficits but we believe they will continue far longer than anyone imagines. They are sustainable.

My thoughts after reading the chapter.

The initial part of the chapter, that talks about the nature of sovereign currency and the fact that it is back by nothing, is mostly factual and depicts the current state of sovereign currencies. The more interesting part is where the author provides an explanation as to the reasons for the wide acceptance of national currencies in private transactions. I agree with the argument that legal tender laws alone are not sufficient to drive acceptance of the national currency. Although the author finds it difficult to accept the explanation that most people accept the national currency as payment in a transaction because it is accepted by everyone, it is not ludicrous. A medium of exchange, like many other things, benefits from network effects. Most saleable commodity acquires the status of a medium of exchange because it becomes widely accepted. Many times this commodity is the national currency.

I agree with the author’s argument that taxes can be used to create a demand for national currency. Taxation ensures that national currency is in demand at least to the extent that it can be used to make tax payments. The author’s proposition in the introductory chapter, that the government can spend first and tax later, can work as long as citizens of the country use the national currency for private transactions in addition to payment of taxes. If for some reasons the national currency is only used for tax payments and not in private transactions then the government will find it very difficult to command more resources by issuing national currency.

The key takeaway from this part is that the government cannot run out of the “wherewithal” to spend. It can, however, run out of public willingness to sell more labour, resources and output for currency – at least at a fixed price.

After reading this part for me the key conclusions are as follows:

• Spend now tax later approach means that excess spending today needs to be paid for by the citizens in future either in the form of higher taxation or higher inflation. 

• The government can continue to run deficits year after year but only as long as the national currency continues to be used in private transactions.

• Taxes alone are not sufficient to create a demand for national currency. Use of national currencies in private transactions cannot be taken for granted because national currencies also serve the function of a store of value in addition to being a unit of account and a medium of exchange. If the national currency becomes a bad store of value due to constant increase in money supply to support ever-increasing government budget deficits, citizens will reduce and in extreme cases abandon the use of national currencies in private transactions.

• Once government loses control over the medium of exchange, it can no longer command resources necessary to run its operations and pursue its policies. 

• Government operations are not self-sustainable on its own and hence they rely on taxation to gather resources required for the government to function. The purpose of the monetary system which includes the national currency is to enable the government to easily fund its operations. It allows the government to print money out of thin air and use it to acquire resources. It is an immense privilege which is invested with the sovereign government. If the government constantly abuses this privilege by running a constant and ever-increasing deficit and debasing the value of national currencies, it can over time lose its privilege. The privilege only works as long as citizens cooperate. Citizens can opt-out by using other media of exchanges which do a better job as a store of value.     

“Sustainability conditions” for government deficits

For me this part of the chapter explains a lot about the rationale behind easy money policies followed by the central banks across the globe. Because of the COVID-19 induced spending, government deficits have shot up dramatically and need to be brought under control. Currently, for most countries the r that they pay on their debt is much higher than the g. Hence, the debt ratio is not sustainable. The solution to this as prescribed in the chapter is to lower the interest rate on government debt below the economic growth rate. This explains a lot why the Fed and ECB want to keep interest rate a sub-zero level for a long time. They want to prevent government debt from exploding.

The possible consequences of a persistent fast-growing deficit provide interesting insights into the monetary and fiscal policies pursued by the governments across the globe.

Inflation: Both ECB and Fed are trying to increase the rate of inflation. We all know that inflation is bad for common citizens. Then why are the central banks pursuing the policy of deliberately increasing the rate of inflation? Because it helps to increase tax revenues so that they grow faster than government spending, thus lowering deficits. Additionally, they help generate “negative” real interest rates. So, the (nominal) growth rate will rise above the interest rate, and reverse the dynamics so that the deficit ratio declines and the debt ratio stops growing. It is very clear that the government is trying to save itself first even at the expense of the wellbeing of common citizens.

Austerity: The reason the austerity never works is that it is politically very unpopular. Also, in addition to correcting the deficit problem, it makes it worse. Raising taxes and reducing expenses ar highly unpopular. Hence, inflation and artificially low-interest rates are the policy of choice for most governments.

Illusion of Wealth: Inflation helps to create an illusion of wealth in the private sector. Private sector wealth and income are increasing but the purchasing power is decreasing at the same time because of inflation. Citizens are earning more and spending more but the same amount of money does not buy the same amount of goods and services over time. Inflation helps to create an illusion of growth and increasing assets prices helps create an illusion of wealth. But in reality, the standard of living for common citizens is getting degraded overtime. All of us are earning more today than we did ten years back but we cannot nearly buy the same amount of goods and services even with our increased earnings than we did ten years back.

“Sustainability” of current account ratios

I agree with the author’s conclusion about the current account ratios at least as far as the US is concerned, because the US Dollar is the world reserve currency. They can continue to run current account deficits longer than any other nation because US Dollar is the lifeblood of the global trade flows and they can print it out of the thin air at will. It would be difficult for any other nation to pull off a feat like this without severely depreciating the value of their domestic currency. It is possible that the US Dollar may be replaced by other currency in future as the world reserve currency but that process will happen gradually over a very long period of time.

Stay tuned for subsequent chapters. Please let me know in the comments section about your thoughts on this chapter. Please subscribe to my blog to get notified when I finish writing the summary of the next chapter.

 Until next time,

 Nirav Gala.