MMT - Chap 4 - Fiscal Operations in a Nation That Issues Its Own Currency

 

In the Chapter the author examines fiscal policy for a government that issues its own currency.

4.1 Introductory principles

Statements that do not apply to a sovereign currency issuer

According to the author, the following statements are common beliefs that actually are false and do not apply to a sovereign currency-issuing government.

•  Governments have a budget constraint (like households and firms) and have to raise funds through taxing or borrowing.

• Budget deficits are evil, a burden on the economy except under some special circumstances (such as a deep recession).

• Government deficits drive interest rates up, crowd out the private sector, and lead to inflation.

• Government deficits take away savings that could be used for investment.

• Government deficits leave debt for future generations; the government needs to cut spending or tax more today to diminish this burden.

• Higher government deficits today imply higher taxes tomorrow, to pay interest and principal on the debt that results from deficits.

Principles that apply to a sovereign currency issuer

According to the author, the following propositions are true of any currency-issuing government, even one that operates with a fixed exchange rate regime.

• The government names a unit of account imposes a tax in that unit, and issues a currency denominated in that unit that can be used to pay the tax.

• The government spends by crediting bank reserves and taxes by debiting bank reserves.

• In this manner, banks act as intermediaries between the government and the non-government sector, crediting depositors’ accounts as the government spends and debiting them when taxes are paid.

• Government deficits mean net credits to banking system reserves and also to deposits at banks.

• The overnight interest rate target is “exogenous”, set by the central bank, but the quantity of reserves is “endogenous”, determined by the needs and desires of private banks.

• The “deposit multiplier” is simply an ex-post ratio of reserves to deposits – it is best to think of deposits as expanding endogenously as they “leverage” reserves, but with no predetermined leverage ratio.

• The Treasury coordinates operations with the central bank to ensure its checks don’t bounce and that fiscal operations do not move the overnight interest rate away from the target.

• For this reason, bond sales are not a borrowing operation (in the usual sense of the term) used by the sovereign government; instead, they are a tool that helps the central bank to hit interest rate targets,

• and the Treasury can always“afford” anything for sale in its own currency, although government always imposes constraints on its spending.

4.2 Effects of sovereign government budget deficits on saving, reserves, and interest rates

Budget deficits and saving

From the discussions in the earlier chapters we know that the deficit spending by one sector generates the surplus or saving for the other sector. When the government deficits spend it creates income and thus savings for non-government sector. Government’s deficits become savings for the non-government sector.

Effects of budget deficits on reserves and interest rates

Deficit spending will initially increase bank reserves because when the treasury spends it leads to simultaneous credit in the account of the recipient and to bank’s reserve account at the central bank. Deficit spending will eventually lead to excess reserves. Hence, their immediate response will be to offer to lend in the overnight fed funds market. When the banking system as a whole has excess reserves, it will drive the fed funds rates lower and even below the target set by the Fed. In order to prevent the rates from dropping below its target the Fed will intervene to remove the excess reserves by conducting an open market sale (OMS) from its stock of treasury bonds. OMS leads to a substitution of bonds for excess reserves: the central bank’s liabilities (reserves) are debited, and the purchasing bank’s reserves are also debited. At the same time, the central bank’s holding of Treasuries is debited and the bank’s assets are increased by the amount of Treasuries purchased.

Complications and private preferences

There are often two objections to the claim that government spending effectively takes place by simultaneously crediting the recipient’s bank account as well as the bank’s reserves: (a) it must be more complicated than this and (b) what if the private sector’s spending and portfolio preferences do not match the government’s budget outcome?

The first of these objections has been carefully dealt with in the previous chapters.

With regard to the second objection, if the government’s fiscal stance is not consistent with the desired saving of the non-government sector, then spending and income adjust until the fiscal outcome and the non-government sector’s balance are consistent. It is impossible for the aggregate saving of the non-government sector to be less than (or greater than) the budget deficit. As shown in the earlier chapters the Balances balance!

4.3 Government budget deficits and the “two-step” process of saving

Saving is actually a two-step process: given income, how much will be saved; and then given saving, in what form will it be held. Thus, many who proffer the second objection – that nongovernment portfolio preferences can deviate from government spending plans – have in mind the portfolio preferences (that is, the second step) of the non-government sector. How can we be sure that the budget deficit that generates an accumulation of claims on government will be consistent with portfolio preferences, even if the final saving position of the non-government sector is consistent with saving desires? The answer is that interest rates (and thus asset prices) adjust to ensure that the nongovernment sector is happy to hold its saving in the existing set of assets.

Here we must turn to the role played by government interest-earning debt (“Treasuries”, or bills and bonds) to gain an understanding. Recipients of government spending then can hold receipts in the form of a bank deposit, can withdraw cash, or can use the deposit to spend on goods, services, or assets. In the first case, no further portfolio changes by the saver occur. In the second case, bank reserves and deposit liabilities are reduced by the same amount. Only cash withdrawals or repayment of loans can reduce the quantity of bank deposits – otherwise, only the names of the account holders change. 

Still, these processes can affect prices – of goods, services, and, most importantly, of assets. If deposits and reserves created by government deficit spending are greater than desired at the aggregate level, then the “shifting of pockets” bids up prices of goods and services and asset prices, lowering interest rates. Those with excess deposits can also repay loans – which wipes both loans and deposits off the balance sheets of banks. The attempt by the non-government sector to shift out of bank deposits will stop once the prices of goods, services, and assets adjust sufficiently so that all the extra deposits are willingly held.

Bond sales provide an interest-earning alternative to reserves

Short-term Treasury bonds are an interest-earning alternative to bank reserves. When they are sold either by the central bank (open-market operations) or by the Treasury (new issues market), the effect is the same: reserves are exchanged for Treasuries. This is to allow the central bank to hit its overnight interest rate target, thus whether the bond sales are by the central bank or the Treasury they should be thought of as a monetary policy operation.

If the central bank pays a support rate on reserves (pays interest on reserve deposits held by banks), then budget deficits tend to lead banks gaining reserves to bid up prices on Treasuries (as they try to substitute into higher interest bonds instead of reserves), lowering their interest rates. This is precisely the opposite of what many believe: budget deficits push interest rates down (not up), all else equal.

Central bank accommodates the demand for reserves

Also following from this perspective is the recognition that the central bank cannot encourage/discourage bank lending by providing/denying reserves. Rather, it accommodates the banking system, providing the amount of reserves desired. Only the interest rate target is discretionary, not the quantity of reserves.

Government deficits and global savings

Many analysts worry that financing of national government deficits requires a continual flow of global savings (in the case of the United States, especially Chinese savings to finance the persistent US government deficit); presumably, if these prove insufficient, it is believed, the government would have to “print money” to finance its deficits, which is supposed to cause inflation. Worse, at some point in the future, the government will find that it cannot service all the debt it has issued so that it will be forced to default.

For the moment, let us separate the issue of foreign savings from domestic savings. The question is whether national government deficits can exceed nongovernment savings in the domestic currency (domestic plus rest-of-world savings). From our analysis above, we see that this is not possible.

Those who claim that the US government must borrow Dollars from thrifty Chinese don’t understand basic accounting. The Chinese do not issue Dollars – the United States does. Every Dollar the Chinese “lends” to the United States came from the United States. In reality, the Chinese receive Dollars (reserve credits at the Fed) from their export sales to the United States (mostly), then they adjust their portfolios as they buy higher-earning Dollar assets (mostly Treasuries). The US government never borrows from the Chinese to “finance” its budget deficit. Actually, the US current account deficit provides Dollar claims to the Chinese, and the US budget deficit ensures these are in the form of “currency”

We conclude: since government deficits create an equivalent amount of nongovernment savings it is impossible for the government to face an insufficient supply of savings.

 4.4 What if foreigners hold government bonds?

Many a times government bonds are held by foreigners. Some commentators are concerned that if US fiscal deficits increase then the foreigners might be unwilling to continue to lend to the US government.  Others worry about the ability of the US government (for example) to pay interest to foreigners. What would be the impact on the interest rates for borrowings and exchange rates?

Interest Rate pressure: As per author bank reserves and bond are substitutes for each other. Foreigners prefer to hold bonds because they pay a higher interest rate than reserves. If foreigners are not happy with the low-interest rates on the bonds they can either let the bonds mature or they can sell the bonds and instead hold reserves. From the perspective of government, it is perfectly sensible to let banks hold more reserves while issuing fewer bonds. Note that means the government is paying lower interest – not higher.

Or the government could offer higher interest rates to sell more bonds (even though there is no need to do so), but this means that keystrokes are used to credit more interest to the bondholders. The government can always “afford” larger keystrokes, but markets cannot force the government’s hand because it can simply stop selling bonds and thereby let markets accumulate reserves instead.

Exchange rate pressure: While foreigners cannot force the government to pay higher interest rate they can vote with foot and sell their holdings of the government debt. This would mean that they will sell the domestic currency and buy other currencies which will cause the domestic currency to depreciate. However, so long as a government is willing to let its exchange rate “float” it need not react to prevent depreciation.

Current accounts and foreign accumulation of claims

US runs a huge current account deficit with China and other nation who in turn have large holdings of US Dollar-denominated government debt. Some fear that suddenly the Chinese might decide to stop accumulating US government debt and that would be detrimental to the US.

For rest of the world to stop accumulating Dollar-denominated assets, it must also stop running current account surpluses against the US. This would imply a decision to stop net exporting to the United States, chances of which are remote. The only way to continue running current account surplus and not accumulate dollar-denominated assets is to offload the Dollars they earn by exporting. In absence of willing buyers, this could lead to depreciate of USD. This in fact will be detrimental to the interests of Chinese because the value of their dollar holding will decline. Depreciation of Dollar would also make Chinese exports expensive which would further hurt them. So, a sudden run by China out of the Dollar is quite unlikely. A slow transition into other currencies is a possibility, and more likely if China can find alternative markets for its exports.

4.5 Currency solvency and the special case of the US dollar

Isn’t the United States special? If a nation runs a current account deficit, by identity there must be a demand for its assets (real or financial) by someone. If that external demand for assets declines, then the current account deficit must also decline.

The two main reasons why the US can run persistent current account deficits are (a) virtually all its foreign-held debt is in Dollars and (b) external demand for Dollar-denominated assets is high, for a variety of reasons.

The first of these implies that servicing the debt is done in Dollars – a currency that is easier for indebted American households, firms, and governments to obtain. The second implies that foreigners are willing to export to the United States to obtain Dollar-denominated assets, meaning that a trade deficit is sustainable so long as the rest of the world wants Dollar assets.

Most nations fall between these two extremes of “special” nations that issue reserve currencies (US, UK, Japan, European Monetary Union, Canada, Australia) and developing nations that face a situation where no one outside their nation wants their currency. The “in-between” nations find some external demand for assets denominated in their currency, which allows them to run current account deficits balanced by capital account surpluses. The governments of these “in-betweeners” can issue their own currency to buy anything for sale that is for sale in their currency (i.e. domestic output) plus things for sale in other currencies by exchanging their currency for foreign currency – which, again, will depend on external demand for assets denominated in their currency. Are they more constrained than the “special” nations that issue reserve currencies? Yes.

However, you can go to any international airport in the world and find quoted exchange rates for dozens of currencies you probably have never heard of. The question is not whether these “nonspecial” countries can exchange their currencies to buy imports, but at what exchange rate.

Sovereign versus no sovereign currencies

It is important to recognize the difference between a fully sovereign, nonconvertible currency and a no sovereign, convertible currency. A government that operates with a no sovereign currency, using foreign currency or a domestic currency convertible to foreign currency (or to precious metal at a fixed exchange rate), faces solvency risk. However, a government that spends using its own floating and nonconvertible currency cannot be forced into default. This is why a country like Japan can run government debt-to-GDP ratios that are more than twice as high as the “high debt” Euro nations (the “PIIGS”: Portugal, Ireland, Italy, Greece, and Spain) while still enjoying extremely low interest rates on sovereign debt.

By contrast, US states, or nations like Argentina that operate currency boards (as it did in the late 1990s), and Euro nations (that adopted the Euro, essentially a foreign currency for them) face downgrades and rising interest rates with deficit ratios much below those of Japan or the United States.

4.7 What about a country that adopts a foreign currency?

A country might choose to use a foreign currency for domestic policy purposes. this nation does not issue Dollars, but rather uses Dollars, it must obtain them to ensure it can make these international payments and can meet domestic cash withdrawals so that Dollar currency can circulate in its economy. It obtains Dollars in the same way that any nation obtains foreign currency because the Dollar really is a foreign currency in terms of ability to obtain cash and Dollar reserves. Hence it can obtain Dollars through exports, through borrowing, through asset sales (including foreign direct investment), and through remittances.

It is apparent that adoption of a foreign currency is equivalent to running a very tight fixed exchange rate regime - one with no wiggle room at all because there is no way to devalue the currency. It provides the least policy space of any exchange rate regime. This does not necessarily mean that it is a bad policy. But it does mean that the nation’s domestic policy is constrained by its ability to obtain the “foreign currency” Dollar. In a pinch, it might be able to rely on US willingness to provide foreign aid (transfers or loans of Dollars). Or it might be able to borrow Dollars from foreign banks with access to them. But that will depend on “the market’s” perception of risk of lending to this nation.

 

Solvency questions and Ponzi finance in a non-sovereign currency

When a sovereign government issues debt, it creates an asset for the private sector without an offsetting private sector liability. Hence government issuance of debt results in net financial asset creation for the private sector. Private debt is debt but government debt is financial wealth for the private sector.

A build-up in private debt should raise concerns because the private sector can reach a point at which it cannot service its debt. But the sovereign government as the monopoly issuer of its own currency can always make payments on its debt by crediting bank accounts – and those interest payments are nongovernment income, while the debt is nongovernment assets. When a private debtor cannot service debt out of income flows it must go further into debt, borrowing to pay interest. This is called Ponzi finance and it is usually dangerous because outstanding debt grows.

For government with a sovereign currency, there is no imperative to borrow, hence it is never in a Ponzi position as it can always service debt using keystrokes. Non sovereign governments can become Ponzi; unable to service existing debt out of tax revenue, they must go to markets to borrow to pay interest.

My thoughts after reading the chapter.

The chapter starts with bold statements about things that do not apply to a sovereign currency issuer. Let’s examine them one by one.

Governments have a budget constraint (like households and firms) and have to raise funds through taxing or borrowing.

This constraint applies as long as the government is not monetising the deficit. Every time the central bank lowers the interest rates its objective is to facilitate monetization of government deficit. So long as central bank keeps lowering interest rates governments do not have a budget constraint.

Budget deficits are evil, a burden on the economy except under some special circumstances (such as a deep recession).

They are not a burden when interest rates are low or near zero, which is the implication of following MMT style deficit financing.

Government deficits drive interest rates up, crowd out the private sector, and lead to inflation.

Interest rate do not go up because of constant increase in money supply. Since the deficits are monetised by central bank the private sector does not get crowded out. There will be inflation down the line because of excess money supply.

Government deficits take away savings that could be used for investment.

 Not as long as newly printed money is used to fund budget deficits.

Government deficits leave debt for future generations; government needs to cut spending or tax more today to diminish this burden.

Yes, increasing deficits means more debt for future generations unless its inflated away with inflation. The price of deficits is ultimately paid by future generation either in from of high taxation or high inflation.

Higher government deficits today imply higher taxes tomorrow, to pay interest and principle on the debt that results from deficits.

Not if you keep interest rate near zero and use inflation to inflate away debt.

Now let’s examine the principles that apply to a sovereign currency issuer.

The government names a unit of account, imposes a tax in that unit, and issues a currency denominated in that unit that can be used to pay the tax.

Yes, no one can deny that

Government spends by crediting bank reserves and taxes by debiting bank reserves. In this manner, banks act as intermediaries between government and the nongovernment sector, crediting depositors’ accounts as government spends and debiting them when taxes are paid. Government deficits mean net credits to banking system reserves and also to deposits at banks.

True, but my question is where does the government gets the money in first place. If not by taxation and borrowing, the only way to get the money is to print it out of thin air by lowering the interest rates to facilitate the financing of deficits.

The overnight interest rate target is “exogenous”, set by the central bank, but the quantity of reserves is “endogenous”, determined by the needs and desires of private banks.

True

The “deposit multiplier” is simply an ex post ratio of reserves to deposits – it is best to think of deposits as expanding endogenously as they “leverage” reserves, but with no predetermined leverage ratio.

True

The Treasury coordinates operations with the central bank to ensure its checks don’t bounce and that fiscal operations do not move the overnight interest rate away from the target.

True

For this reason, bond sales are not a borrowing operation (in the usual sense of the term) used by the sovereign government; instead they are a tool that helps the central bank to hit interest rate targets.

Yes, it acts both ways. It helps to suck out the excess reserves from the system to prevent the interest rates from falling too much and also helps to fund the deficit. Government first supplies the money which is then used to purchase the bonds.

and the Treasury can always “afford” anything for sale in its own currency, although government always imposes constraints on its spending.

Yes, Treasury has the money printer. It can get afford anything for sale in its own currency.

 The rest of the chapter is dedicated to explaining effects of budget deficits on various macroeconomics factors.

Budget deficits and saving

From the accounting equation spending by government equals saving for the private sector. Government deficits equal non-government savings. This is the case only in the year the government runs the deficit. If it stops running the deficit or tries to reduce it that would mean that the private sector will lose their source of income. So, they will have to spend the savings to fund the consumption. If the government spending does not increase the productive capacity of the economy it will lead to inflation, as too much money will be chasing too few goods.

Effects of budget deficits on reserves and interest rates

When the government deficit spends, the immediate impact is increase in reserves in the banking system. These excess reserves will lead to a decline in interest rate. If the rate falls below the target rate the central bank will have to issue new government debt to drain the excess reserves from the system.

The above explanation makes sense. But it only explains the second part of the story which is what happens immediately after the government has deficit spent. It does not explain the first part of the story which is what steps the government needs to take to get money into its own bank account in order to deficit spend.  The question is where does the government get the money to deficit spend first.

Let’s examine the situation created by Covid-19 pandemic. Because of the pandemic governments ordered a lockdown of the economy which halted all the economic activity. This led to a decline in government tax revenue, in addition, to increase in healthcare spending required to fight the virus. So, there is a budget deficit that needs to be funded. How does the government get the money to spend? It needs to borrow.

When the government borrows the banks exchange their reserve balance for government bonds because bonds pay higher interest. This drains the reserves out of the system. The pandemic created a lot of uncertainty so people want to hold a lot of cash on hand which in turn increases the demand for bank reserves. If the central bank does not take any action all of these factors will lead to an increase in fed funds rates. The central banks understand this very well. Hence, the central banks have pre-emptively responded with the cutting of interest rate as soon as the lockdowns were announced. By cutting the interest rates they have flooded the banking system with excess reserves in the name of ensuring the smooth functioning of the system. But the real objective is to facilitate borrowing by governments in order to fund deficits. Hence, government deficits will drive interest rates up, crowd out the private sector unless the central bank pre-emptively cuts interest rates and floods the system with excess reserves.

Complications and private preferences

The author says that if the government’s fiscal stance is not consistent with the desired saving of the non-government sector, then spending and income adjust until the fiscal outcome and the non-government sector’s balance are consistent. The way this adjustment happens is that interest rates (and thus asset prices) adjust to ensure that the nongovernment sector is happy to hold its savings in the existing set of assets. These processes can affect prices – of goods, services, and, most importantly, of assets. If deposits and reserves created by government deficit spending are greater than desired at the aggregate level, then the “shifting of pockets” bids up prices of goods and services and asset prices, lowering interest rates. The attempt by the non-government sector to shift out of bank deposits will stop once the prices of goods, services, and assets adjust sufficiently so that all the extra deposits are willingly held.

If we look at the capital markets world over today, we can witness the effects of the adjustment process that the author has described above. The private sector is not happy with the low-interest rates on government bonds. Hence, all this excess money has started pouring into other asset classes. Most of the stimulus spending has ended up propping the prices of stocks and corporate bonds because they offer higher returns than government bonds. That is why the stock markets are making new highs even though the economy is a total mess. Currently, there is a lot of money sloshing around in the system with not many productive opportunities to invest in because the economy is not allowed to function freely. Hence, it ends up bidding the prices of other risk assets. But over time as the money makes way into the economy, it can lead to bubbles in other assets as well as inflation.

Government deficits and global savings

I agree with what the author says in this section. As long as the central bank lowers the rate and floods the banking system with reserves it is impossible for the government to face an insufficient supply of savings.

4.4 What if foreigners hold government bonds?

I agree with the author’s conclusion about interest rate pressure and exchange rate pressures. Excessive budget deficits can lead to depreciation of the exchange rate. As long as currency depreciation does not create an issue for the government it can continue to run deficits. If it does create one then it imposes constraints on the government’s ability to run a deficit.

Current accounts and foreign accumulation of claims

I agree with the author’s conclusion in this section as well.  A sudden run by China out of the Dollar is quite unlikely as it will not be in their interest. A slow transition into other currencies is a possibility, and more likely if China can find alternative markets for its exports.

4.5 Currency solvency and the special case of the US dollar

I agree with the author’s conclusion in this section as well. While governments can manipulate the money supply and interest rate domestically to get something for nothing it does not work in the foreign exchange market. In the foreign exchange market, the exchange rate is determined by demand and supply conditions which cannot be easily manipulated. In order to purchase something which is available for sale in foreign currency, there should also be a demand for goods available for sale in domestic currency. Without it, the exchange would be impossible. If the demand for goods available for sale in domestic currency is low it becomes progressively more expensive to purchase goods available for sale in foreign currency.

I agree with the author’s conclusion in the section on Sovereign versus no sovereign currencies and 4.7 What about a country that adopts a foreign currency?

Solvency questions and Ponzi finance in a non-sovereign currency

I agree with some of the author’s conclusion in the section. A build-up in private debt should raise concerns because the private sector can reach a point at which it cannot service its debt. But the sovereign government as the monopoly issuer of its own currency can always make payments on its debt by crediting bank accounts. The only issue is that the purchasing power of the currency declines over time due to inflation. The government does not actually default. But the money that is paid back does not purchase the same quantity and quality of goods and services. This is equivalent to getting a hair cut on your debt investments. The impact of both of them is same, reduction in your purchasing power. While the government may not default but it may increasingly find it difficult to find takers for its currency and debts.

Overall, this is a really interesting chapter and provided a lot of insights on working of the fiscal operations, the fiscal-monetary coordination and impact of fiscal policy on various economic factors. It explains why stock markets are making new highs when the economy is a total mess and the policy actions that governments and central banks took during this COVID-19 pandemic.

Hope you like it as well.

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.