Last weekwe examined Milton Friedman’s version of Functional Finance, which we found tobe remarkably similar to Abba Lerner’s. If the economy is operating below fullemployment, government ought to run a budget deficit; if beyond full employmentit should run a surplus. He also advocated that all government spendingshould be financed by “printing money” and taxes would destroy money. That, aswe know, is an accurate description of sovereign government spending—exceptthat it is keystrokes, not money printing. Deficits mean net money creation, throughnet keystrokes. The only problem with Friedman’s analysis is that he did notaccount for the external sector: he wanted a balanced budget at fullemployment, but if a country tends to run a trade deficit at full employment,then it must have a government budget deficit to allow the private sector torun a balanced budget—which is the minimum we should normally expect.
Somehow allthis understanding was lost over the course of the postwar period, replaced by“sound finance” which is anything but sound. It was based on an inappropriateextension of the household “budget constraint” to government. This is obviouslyinappropriate—households are users of the currency, while government is theissuer. It doesn’t face anything like a household budget constraint. How couldeconomics have become so confused? Let us see what Paul Samuelson said, andthen turn to proper policy to promote long term growth.
Functional Finance versus Superstition. The functional finance approach ofFriedman and Lerner was mostly forgotten by the 1970s. Indeed, it was replacedin academia with something known as the “government budget constraint”. Theidea is simple: a government’s spending is constrained by its tax revenue, itsability to borrow (sell bonds) and “printing money”. In this view, governmentreally spends its tax revenue and borrows money from markets in order tofinance a shortfall of tax revenue. If all else fails, it can run the printingpresses, but most economists abhor this activity because it is believed to behighly inflationary. Indeed, economists continually refer to hyperinflationaryepisodes—such as Germany’s Weimar republic, Hungary’sexperience, or in modern times, Zimbabwe—asa cautionary tale against “financing” spending through printing money.
Note thatthere are two related points that are being made. First, government is“constrained” much like a household. A household has income (wages, interest,profits) and when that is insufficient it can run a deficit through borrowingfrom a bank or other financial institution. While it is recognized thatgovernment can also print money, which is something households cannot do, theseis seen as extraordinary behaviour—sort of a last resort. There is norecognition that all spending bygovernment is actually done by crediting bank accounts—keystrokes that are moreakin to “printing money” than to “spending out of income”. That is to say, thesecond point is that the conventional view does not recognize that as theissuer of the sovereign currency, government cannot really rely on taxpayers or financial markets to supply itwith the “money” it needs. From inception, taxpayers and financial markets canonly supply to the government the “money” they received from government. That is to say, taxpayers pay taxes usinggovernment’s own IOUs; banks use government’s own IOUs to buy bonds fromgovernment.
Thisconfusion by economists then leads to the views propagated by the media and bypolicy-makers: a government that continually spends more than its tax revenueis “living beyond its means”, flirting with “insolvency” because eventuallymarkets will “shut off credit”. To be sure, most macroeconomists do not makethese mistakes—they recognize that a sovereign government cannot really becomeinsolvent in its own currency. They do recognize that government can make allpromises as they come due, because it can “run the printing presses”. Yet, theyshudder at the thought—since that would expose the nation to the dangers ofinflation or hyperinflation. The discussion by policy-makers—at least in the US—is far moreconfused. For example, President Obama frequently asserted throughout 2010 thatthe USgovernment was “running out of money”—like a household that had spent all themoney it had saved in a cookie jar.
So how didwe get to this point? How could we have forgotten what Lerner and Friedmanclearly understood?
In a veryinteresting interview in a documentary produced by Mark Blaug on J.M. Keynes,Samuelson explained:
“I think there is an elementof truth in the view that the superstition that the budget must be balanced atall times [is necessary]. Once it is debunked [that] takes away one of thebulwarks that every society must have against expenditure out of control. Theremust be discipline in the allocation of resources or you will have anarchisticchaos and inefficiency. And one of the functions of old fashioned religion wasto scare people by sometimes what might be regarded as myths into behaving in away that the long-run civilized life requires. We have taken away a belief inthe intrinsic necessity of balancing the budget if not in every year, [then] inevery short period of time. If Prime Minister Gladstone came back to life he would say “uh, oh what youhave done” and James Buchanan argues in those terms. I have to say that Isee merit in that view.”
The beliefthat the government must balance its budget over some timeframe is likened to a“religion”, a “superstition” that is necessary to scare the population intobehaving in a desired manner. Otherwise, voters might demand that their electedofficials spend too much, causing inflation. Thus, the view that balancedbudgets are desirable has nothing to do with “affordability” and the analogiesbetween a household budget and a government budget are not correct. Rather, itis necessary to constrain government spending with the “myth” precisely becauseit does not really face a budget constraint.
The US (and manyother nations) really did face inflationary pressures from the late 1960s untilthe 1990s (at least periodically). Those who believed the inflation resultedfrom too much government spending helped to fuel the creation of the balancedbudget “religion” to fight the inflation. The problem is that what started assomething recognized by economists and policymakers to be a “myth” came to bebelieved as the truth. An incorrect understanding was developed. Originally themyth was “functional” in the sense that it constrained a government thatotherwise would spend too much, creating inflation. But like many useful myths,this one eventually became a harmful myth—an example of what John KennethGalbraith called an “innocent fraud”, an unwarranted belief that preventsproper behaviour. Sovereign governments began to believe that the really couldnot “afford” to undertake desired policy, on the belief they might becomeinsolvent. Ironically, in the midst of the worst economic crisis since theGreat Depression of the 1930s, President Obama repeatedly claimed that the US governmenthad “run out of money”—that it could not afford to undertake policy that mostbelieved to be desired. As unemployment rose to nearly 10%, the government wasparalysed—it could not adopt the policy that both Lerner and Friedmanadvocated: spend enough to return the economy toward full employment.
Ironically,throughout the crisis, the Fed (as well as some other central banks, includingthe Bank of England and the Bank of Japan) essentially followed Lerner’s secondprinciple: it provided more than enough bank reserves to keep the overnightinterest rate on a target that was nearly zero. It did this by purchasingfinancial assets from banks (a policy known as “quantitative easing”), inrecord volumes ($1.75 trillion in the first phase, with a planned additional $600billion in the second phase). Chairman Bernanke was actually grilled inCongress about where he obtained all the “money” to buy those bonds. He(correctly) stated that the Fed simply created it by crediting bankreserves—through keystrokes. The Fed can never run out “money”; it can affordto buy any financial assets banks are willing to sell. And yet we have thePresident (as well as many members of the economics profession as well as mostpoliticians in Congress) believing government is “running out of money”! Thereare plenty of “keystrokes” to buy financial assets, but no “keystrokes” to paywages.
Thatindicates just how dysfunctional the myth has become.
A Budget Stance to Promote Long Term Growth. The lesson that can be learned fromthat three decade experience of the US is that in the context of a privatesector desire to run a budget surplus (to accumulate savings) plus a propensityto run current account deficits, the government budget must be biased to run adeficit even at full employment. Thisis a situation that had not been foreseen by Friedman (not surprising since theUSwas running a current account surplus in the first two decades after WWII). Theother lesson to be learned is that a budget surplus (like the one PresidentClinton presided over) is not something to be celebrated as anaccomplishment—it falls out of an identity, and is indicative of a privatesector deficit (ignoring the current account). Unlike the sovereign issuer ofthe currency, the private sector is a user of the currency. It really does facea budget constraint. And as we now know, that decade of deficit spending by theUSprivate sector left it with a mountain of debt that it could not service. Thatis part of the explanation for the global financial crisis that began in the US.
To be sure,the causal relations are complex. We should not conclude that the cause of the private deficit was the Clinton budget surplus; and we should not conclude thatthe global crisis should be attributed solely to US household deficit spending. Butwe can conclude that accounting identities do hold: with a current accountbalance of zero, a private domestic deficit equals a government surplus. And ifthe current account balance is in deficit, then the private sector can run asurplus (“save”) only if the budget deficit of the government is larger thanthe current account deficit.
Finally,the conclusion we should reach from our understanding of currency sovereigntyis that a government deficit is more sustainable than a private sector deficit—thegovernment is the issuer, the household or the firm is the user of thecurrency. Unless a nation can run a continuous current account surplus, thegovernment’s budget will need to be biased to run deficits on a sustained basisto promote long term growth.
However, weknow from our previous discussion that fiscal policy space depends on theexchange rate regime—the topic of the next blog.
Further, wewant to be clear: the appropriate budget stance depends on the balance of theother two sectors. A nation that tends to run a current account surplus can runtighter fiscal policy; it might even be able to run a sustained governmentbudget surplus (this is the case in Singapore—which pegs its exchangerate, and runs a budget surplus because it runs a current account surplus whileit accumulates foreign exchange). A government budget surplus is alsoappropriate when the domestic private sector runs a deficit (given a currentaccount balance of zero, this must be true by identity). However, for thereasons discussed above, that is not ultimately sustainable because the privatesector is a user, not an issuer, of the currency.
Finally, we must note that it is not possible for all nations to runcurrent account surpluses—Asian net exporters, for example, rely heavily onsales to the US, which runs a current account deficit to provide the Dollarassets the exporters want to accumulate. We conclude that at least somegovernments will have to run persistent deficits to provide the net financialassets desired by the world’s savers. It makes sense for the government of thenation that provides the international reserve currency to fill that role. Forthe time being, that is the US government.
