There has been a lot of talk regarding ‘post-truth’ in recent years. We are increasingly being told that we have entered a new era of politics: the post-truth era. But what does the term mean exactly? The Oxford English Dictionary – which chose the term as its 2016 word of the year – defines post-truth politics (or post-factual politics) as a political culture ‘in which objective facts are less influential in shaping public opinion than appeals to emotion and personal belief’. According to this commonly accepted definition, however, it hard to see what is so novel about the so-called post-truth era: using biased or misleading information – or ‘alternative facts’, to use another fashionable term – to influence public opinion is a tactic as old as politics itself. It’s called propaganda. So how should we explain the post-truth hysteria that is currently engulfing the West? Are we to believe that the same political-media establishment that blatantly lied about Iraq’s possession of weapons of mass destruction to justify the aggression and occupation of the country, to cite the most flagrant example of establishment-sponsored propaganda in recent years, has taken up a sudden interest in ‘the truth’, however loosely we define the concept? Such an answer is clearly laughable.
A more sensible explanation is that Western elites are increasingly losing their ability to control the flow of information to the general public – and thus to determine the outcome of electoral disputes, as seen in the 2016 British referendum and US presidential election – due to the rise of social media and (mostly) Internet-based alternative information platforms (as well as the counter-propaganda of non-Western countries such as Russia and China). This represents a clear threat to the ruling classes. In such a context, the political and corporates elites can only hope indirectly to control the flow of information that is beyond their sphere of influence, by using the mainstream media and other channels (such as academia) that they do effectively control to fix the premises of discourse by circumscribing the terms of acceptable debate – the ‘real news’ of the established media vis-à-vis the ‘fake news’ of social media and the alternative media more generally – thus excluding the viability of alternative viewpoints, whether fact-based or not. The aim of this form of ‘soft propaganda’ is not to uphold the truth against post-truth, but rather to uphold the establishment’s account of the way things are, which often has very little to do with the truth or reality, against alternative accounts of reality that may threaten the dominant order. There is nothing particularly new about this form of propaganda either. It has been going on for decades.
Nowhere is this more evident than in the realm of macroeconomics, and particularly the narrative that has been spun about the capacities (or alleged lack thereof) of national governments that issue their own currency (which encompasses almost all nations). In essence, the dominant narrative in macroeconomics is based on what we might call ‘fake knowledge’. Mainstream macroeconomists, who profess an abiding faith in the ability of the self-regulated market to deliver optimal outcomes, declared some years before the crisis, with an arrogance characteristic of the profession, that the business cycle was dead. They claimed that large swings in macroeconomic performance (recessions and mass unemployment, and booms and busts), which had dominated the attention of economic policymakers in the post-war period, were now a thing of the past. University of Chicago professor and Nobel Prize in Economics winner Robert Lucas Jr (in)famously declared in 2003 that ‘macroeconomics in this original sense has succeeded: its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades’.1 The former US Federal Reserve Bank governor, Ben Bernanke, followed that up with the claim that the world was enjoying an unprecedented period of ‘great moderation’ because governments had prioritised monetary policy to concentrate purely on price stability and the pursuit of fiscal surpluses.2
Just before the financial crisis revealed its worst, Olivier Blanchard, then chief economist at the IMF, claimed that ‘the state of macro is good’.3 He asserted that a ‘largely common vision has emerged’ in macroeconomics, with a ‘convergence in methodology’. He also noted that the dominant approach in macroeconomics had ‘become a workhorse for policy and welfare analysis’ because it is ‘simple, analytically convenient [and] reduces a complex reality to a few simple equations’. It didn’t seem to matter to these economists that in mainstream models ‘there is no unemployment’ because according to the mainstream paradigm all fluctuations in unemployment are the result of workers making the optimal choice between work and leisure. The public was led to believe that these mainstream economists had triumphed over the old Keynesian interventionists who had overregulated the economy, sucked the spirit out of private entrepreneurs, allowed trade unions to become too powerful and bred generations of indolent and unmotivated individuals who only aspired to live on income support payments. The dominant narrative was that with the economic cycle now under control, economic policy should concentrate on deregulating labour and financial markets and reducing income support payments to the unemployed, so that the market could work more efficiently.
Recently, Paul Romer, who earned his PhD in economics in the 1980s at the University of Chicago, the temple of neoliberal economics, provided a scathing attack of his own profession in a paper titled ‘The Trouble With Macroeconomics’.4 Romer describes mainstream macroeconomics as having been in a state of ‘intellectual regress … for more than three decades’, culminating in the obsession for so-called Dynamic Stochastic General Equilibrium (DSGE) New Keynesian models – which Romer describes as ‘post-real’ – that lie at the heart of mainstream economics. These are highly complex and abstract mathematical models that attempt to explain aggregate economic phenomena, such as economic growth, business cycles and the effects of monetary and fiscal policy, on the basis of microeconomic principles that have no bearing on macroeconomic reality, which the models erroneously assume to be governed by stable causal mechanisms. That is because the models in question rely on assumptions about human behaviour that belie the knowledge adduced by social scientists that actually study such behaviour (such as psychologists, sociologists, etc.).
It should come as no surprise that mainstream economists first failed to predict the financial crisis, and then proposed ‘remedies’ (i.e. austerity and wage repression) that dramatically worsened it. In 2011, the IMF’s IEO released a caustic assessment of the institution’s performance in the lead-up to the financial crisis.5 The IEO identified neoliberal ideological biases within the IMF, and determined that it had failed to give adequate warning of the impending financial crisis because it was ‘hindered by a high degree of groupthink’, which, among other things, suppressed ‘contrarian views’. The report stated:
The prevailing view among IMF staff – a cohesive group of macro-economists – was that market discipline and self-regulation would be sufficient to stave off serious problems in financial institutions. They also believed that crises were unlikely to happen in advanced economies, where ‘sophisticated’ financial markets could thrive safely with minimal regulation of a large and growing portion of the financial system.6
The report also says that ‘IMF economists tended to hold in highest regard’ DSGE New Keynesian economic models proven to be inadequate.7 Willem Buiter, hardly a radical economist, described DSGE models as useless ‘self-referential, inward-looking distractions at best’, which ‘exclude everything relevant to the pursuit of financial stability’.8 Paul Krugman noted that mainstream economists were blind ‘to the very possibility of catastrophic failures in a market economy’ and that their policy prescriptions, based on an unjustified belief in the efficiency of markets, had created the circumstances that would lead to the crisis.9 As the worst economic crisis in 80 years was building, most economists were waxing lyrical in their own world of self-aggrandisement and self-congratulation.
Simply put, the entire edifice of mainstream macroeconomics is built on a sequence of interrelated lies and myths that have no connection to reality, but reinforce the erroneous view that a self-regulating private market with minimal government interference will deliver maximum wealth for all. To address criticism that mainstream economists play around with ‘models’ that have little correspondence to reality, Milton Friedman famously stated that it is not how ‘real’ the models are but how well they predict real outcomes that should guide their credibility. Even on that flawed premise, mainstream macroeconomics has proven to be a disastrous failure. The financial crisis led to rather extreme policy responses from governments and central banks. All the mainstream predictions of the outcomes of these policies (for example, that the large bond-buying exercises conducted by central banks would be inflationary, or that the significant increase in fiscal deficits would drive up interest rates) have been proven to be completely wrong.
It is easy to conclude that those who hang on to these failed mainstream approaches are little more than cult worshippers who have lost all scientific credibility. Yet they maintain their hegemony in several ways. Economics students are forced to use textbooks that give false accounts of how the financial sector works; they are brainwashed with mythical accounts about the impact of the government on private markets; and, above all, they are taught that if markets are left to their own devices, the outcomes will be superior to those that involve regulation or government oversight. They also control hiring processes in our universities, access to the ‘high status’ publication outlets and major research funding bodies, and, importantly, create networks that allow for transition between the academy, business and government. These networks are a pervasive and powerful force for discipline. Advantages (publications, research grants, promotions, consulting opportunities, influence, etc.) accrue to those who conform to the rules. Socialisation begins in one’s student days and persists as one progresses through a career.
In this sense, mainstream economics, with its reliance on blind belief rather than empirical evidence, is more akin to a religion – with economists playing the role of high priests, custodians of a body of knowledge too complex to be understood by common people – than a science. In recent decades, this has led to the emergence of what Joe Earle and others call an ‘econocracy’: ‘a society in which political goals are defined in terms of their effect on the economy, which is believed to be a distinct system with its own logic that requires experts to manage it’.10 That expertise – which has allowed policymakers throughout the neoliberal era to (mis)represent to the public unpopular political decisions as being neutral technical decisions, separate from politics and class interests, in yet another form of depoliticisation – is now being increasingly challenged. To understand why there is so much resistance to abandoning failed economic theories, we need to understand that the mainstream economics paradigm is much more than a set of theories that economics professors indoctrinate their students with. Mark Blyth notes that mainstream economic theories ‘enshrine different distributions of wealth and power and are power resources for actors whose claims to authority and income depend upon their credibility’, which explains, in part, why there is such resistance to abandoning them, even though it is clear that they are bereft of any evidential standing.11
Considering all this, it is hardly surprising that these models completely and utterly failed to predict the financial crisis and subsequent Great Recession. Neither is it surprising that citizens are losing faith in the economics profession. In this respect, the outcome of the British referendum on the country’s membership of the European Union was a watershed moment: despite months of incessant fear-mongering by virtually all parties of the British and European political spectrum, all major international organisations and media outlets, and (almost) the entire economics profession – which unanimously claimed that an ‘exit’ victory would have apocalyptic consequences for the UK, instantly causing a financial meltdown and plunging the country into a deep recession – the majority of voters opted for Brexit anyway. In doing so, they proved economists wrong once again, since none of the day-after catastrophic scenarios predicted in the run-up to the referendum occurred. In this sense, the Brexit vote was not simply a rejection of the political establishment; it was also a rejection of the dominant economic narrative peddled by the self-appointed experts of the academic and economic establishment. The reasons are easily explained. As Ann Pettifor wrote, the hardship experienced by a growing number of citizens – in the form of low wages, insecure low-skilled jobs, bad housing, high rents and public sector austerity – ‘is indirectly a consequence of the economics profession’:
Economists led the way to financial liberalisation of the past forty years, which led to soaring levels of debt, crises and financial ruin. Economists dictated the terms for austerity that has so harmed the economy and society over the past years. As the policies have failed, the vast majority of economists have refused to concede wrongdoing.12
As we have seen, many of the myths of mainstream economics – such as those regarding the alleged virtues of ‘free trade’ and the ‘free market’ – concern concepts that find no correspondence in actually existing capitalism, which relies heavily on measures designed and promoted by the state on behalf of capital, and thus can be easily dismissed as simple ideological veils designed to shield from our view the true nature of capitalist exploitation and regimentation, which we have analysed at length in previous chapters.
Other myths and ‘alternative facts’, however, continue to inform policymaking and are therefore much more dangerous. Most of these relate to the impact of monetary and fiscal policy, the principle tools available to national governments. These claims include: that fiscal deficits inevitably lead to inflation and impose crippling debt burdens on future generations; that fiscal deficits do not influence aggregate demand because consumers and firms will factor into their spending decisions the future tax burden (needed, the argument goes, to ‘pay off’ the deficit/debt) and thus will increase their savings today to meet their future tax obligations – the ‘Ricardian equivalence hypothesis’; that government borrowing (allegedly needed to ‘fund’ the deficit) competes with the private sector for scarce available funds and thus drives up interest rates, which reduces private investment – the ‘crowding out’ hypothesis; that an excessive debt will make the government insolvent; that if governments cut their spending, the private sector will ‘crowd in’ to fill the gap – another version of the ‘Ricardian equivalence’ myth, and many more.
Why do these myths continue to hold so much sway – among economists and policymakers alike – despite the lack of empirical evidence and the growing body of theoretical research (even from mainstream sources, as we have seen) that disproves them? The reasons suggested are numerous and often overlapping: ideology, lobbying and vested interests are among the main ones. This is how John Maynard Keynes, reflecting on the ‘victory’ of the neoclassical model – the precursor to neoliberalism – in the early twentieth century, explained its success:
It must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected. That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority.13
Paraphrasing Keynes, we could thus posit that the power of mainstream economics resides in the fact that it explains much social injustice as the inevitable consequence of the objective constraints faced by policymakers and state apparatuses, which obviously attracts to it the support of the dominant social forces (and of policymakers themselves). The fact that the policies arising from modern mainstream economics benefit only the richest – the so-called ‘1 per cent’ – would appear to validate this hypothesis. In other words, if these theories and policies continue to prove themselves incapable of restoring prosperity it is not only because their fundamental macroeconomic assumptions are not grounded in reality – it is because they were never intended to do so. More troubling, however, is the fact that these myths also hold considerable sway among progressive and radical thinkers and politicians. These myths represent a huge obstacle to the conceptualisation of a radical alternative to neoliberal (or post-neoliberal) capitalism. It is to these to that we will now turn our attention.
One of the most pervasive and persistent myths – which undergirds many of the myths outlined above – is the assumption that governments are revenue-constrained, that is, that they need to ‘fund’ their expenses through taxes or, if they register a fiscal deficit (i.e. if expenses exceed revenues), through debt. This leads to the corollary that governments have to ‘live within their means’, since ongoing deficits will inevitably result in an ‘excessive’ accumulation of debt, which in turn is assumed to be ‘unsustainable’ in the long run. Former US president, Barack Obama, reiterated this myth when he announced, in December 2009, that the country ‘[does not] have enough public dollars to fill the hole of private dollars that was created as a consequence of the crisis’.14 The problem with Obama’s assertion is that it is simply not true. As we will see, monetarily sovereign (or currency-issuing) governments – which nowadays include most governments – are never revenue-constrained because they issue their own currency by legislative fiat.
It wasn’t always this way. Under the Bretton Woods system of fixed exchange rates and gold convertibility that was in place prior to 1971, governments were indeed limited in their spending capacity by the value of the gold held by the central bank. This was because the outstanding stock of money that the central bank would issue was proportional to its gold reserves; if a government wanted to spend more, it had to reduce the money held by the non-government sector using taxation and/or bond sales. Clearly, the decision to enter this type of monetary system was voluntary, but once the decision had been taken, the government was bound to operate in that manner. Institutional machinery was then established to facilitate the issuing of bonds to the private markets, although central banks could still purchase government debt. In some periods, central banks purchased significant amounts of government debt. That system came to an end in August 1971, when US President Nixon abandoned gold convertibility and ended the system of fixed exchange rates. Once governments started to adopt so-called fiat currency monetary systems and flexible exchange rates in the 1970s, all the spending caps and debt limits that had some operational significance under the Bretton Woods system became irrelevant.
Modern currencies are often called fiat currencies – from the Latin word fiat (‘it shall be’) – because there is no promise made by the government to redeem them for precious metal. Their value is proclaimed by ‘fiat’: the government merely announces that a coin is worth, let’s say, a half dollar without holding a reserve of precious metal equal in value to a half dollar. A consequence of this is that governments that issue their own currencies no longer have to ‘fund’ their spending: technically, they can simply create the necessary money ‘out of thin air’. They never need to ‘finance’ their spending through taxes or selling debt to the private sector, since the level of liquidity in the system is not limited by gold stocks, or anything else. In other words, governments are free from the revenue constraints that existed under the Bretton Woods system. The reality is that currency-issuing governments such as those of Australia, Britain, Japan and the US can never ‘run out of money’ or become insolvent. These governments always have an unlimited capacity to spend in their own currencies: that is, they can purchase whatever they like, as long as there are goods and services for sale in the currency they issue. At the very least, they can purchase all idle labour and put it back to productive use. This ‘fundamental principle’ was spelled out even in a recent Deutsche Bank report: ‘Unlike any corporate, government or household, a central bank has no reason to be bound by its balance sheet or income statement. It can simply create money out of thin air (a liability) and buy an asset or give the liability (money) out for free.’15
Moreover, a flexible exchange rate means that governments no longer have to constrain their expenditures to meet the central bank requirements to sustain a fixed parity against a foreign currency. This, of course, does not apply to countries that are part of the EMU: they effectively use a foreign currency, much like a state government in, say, the US or Australia and thus they do face the risk of insolvency. The ECB, which issues the currency in the eurozone, however, like any other central bank, can never run out of euros nor become insolvent.
However, most of the analysis appearing in mainstream macroeconomics textbooks, which filters into the public debate and underpins the cult of austerity (and, alas, most left responses to it), continues to ignore the post-1971 shift and to rely on gold standard logic, which does not apply to modern fiat monetary systems. This is evident in the flawed analogy often made between the household budget and the sovereign government budget. When former British prime minister, David Cameron, said in June 2011 that ‘if you have maxed out your credit card, if you put off dealing with the problem, the problem gets worse’,16 he was inferring that the government deficit is just like credit card debt and that Britain was facing bankruptcy. He was misleading susceptible voters by invoking the false neoliberal analogy between national government budgets and household budgets. This analogy resonates strongly with voters because it attempts to relate the more amorphous finances of a government with our daily household finances. We know that we cannot run up our household debt forever and that we have to tighten our belts when our credit cards are maxed out. We can borrow to enhance current spending, but eventually we have to sacrifice spending to pay the debts back. We intuitively understand that we cannot indefinitely live beyond our means. We can quite literally ‘run out of money’.
Neoliberal ideologues draw an analogy between the two because it implies that government deficits – just like ‘household deficits’ – are intrinsically reckless. This analogy, however, is false at the most elemental level: households are users of the currencies, meaning that they have to seek funds before they can spend; sovereign governments, on the other hand, issue the currency that the households use. Thus, they can consistently spend more than their revenues because they can, technically speaking, create the currency out of thin air if necessary. They face no solvency constraint precisely because they face no revenue constraint. This is the exact opposite of what most students learn in mainstream macroeconomic textbooks, which typically use the flawed analogy between the household budget and the sovereign government budget to argue that the same principles that constrain the former apply to the government. Stephanie Bell noted that that the erroneous understanding that a student will gain from a typical macroeconomics course is that ‘the role of taxation and bond sales is to transfer financial resources from households and businesses (as if transferring actual dollar bills or coins) to the government, where they are re-spent (that is, in some sense “used” to finance government spending)’.17 This is true for local governments and states that do not issue the currency. It is also not too far from the truth for nations that adopt a foreign currency or peg their own to gold or foreign currencies. However, as mentioned, this is not the case for governments that issue their own sovereign currency without a promise to convert at a fixed value to gold or a foreign currency (that is, governments that float their currencies).
While the exact institutional details can vary from nation to nation, governments typically spend by drawing on a bank account they have at the central bank – which, in itself, is a creature of the state and, irrespective of legal status, is effectively part of government. An instruction is sent to the central bank from the treasury to transfer some funds out of this account into an account in the private sector, which is held by the recipient of the public spending. Similarly, when the tax department receives revenue it asks the central bank to record the receipts in its central bank account. The private banking sector facilitates a transaction that reduces the funds available in the bank account of the taxpayer. No printing presses are involved in either transaction. Computer operators in the central bank and the private banks just type numbers that are recorded by the electronic accounting systems in the various banks to signify how much the government wishes to spend and/or how much it has received. It is a very orderly process and goes on hour by hour, day by day and year by year. All government spending is enacted in this way.
As we will see, accounting rules typically require governments to have sufficient funds in their account at the central bank before they can spend, and, if there are not sufficient funds available (that is, if expenses exceed revenues), to ‘cover’ the deficit through debt issuance. In the latter case, the government typically credits the private bank’s account with treasury securities – the sale of government bonds usually involves a debt auction, which only a select number of banks or securities broker-dealers (known as primary dealers) are permitted to participate in – and the private bank in turn credits the treasury’s account at the central bank with reserves of equal value. However, we should not be misled into thinking that a sovereign government can run out of funds or purchasers of public debt, or that the government will eventually have to raise taxes in order to pay back the debt. The government typically reimburses the debt by ‘rolling it over’ (that is, issuing new debt as the old debt matures), though it could simply extinguish the debt by issuing new fiat money.
Similarly, we should not fall prey to the neoliberal narrative that a fiscal surplus (revenues greater than spending) represents ‘public saving’, which can be used to fund future public expenditure. In rejecting the notion that public surpluses create a cache of money that can be spent later, Mitchell and Mosler note:
Government spends by crediting a reserve account. That balance doesn’t ‘come from anywhere’, as, for example, gold coins would have had to come from somewhere. It is accounted for but that is a different issue. Likewise, payments to government reduce reserve balances. Those payments do not ‘go anywhere’ but are merely accounted for. In the USA situation, we find that when tax payments are made to the government in actual cash, the Federal Reserve generally burns the ‘money’. If it really needed the money per se surely it would not destroy it.18
Ultimately, this accounting smokescreen is unnecessary. Technically, the government doesn’t ‘need’ pre-existing funds to spend; neither does it ‘need’ to offset the deficit by issuing debt to the private sector, given that it can create the currency out of thin air. Mainstream textbooks sometimes admit that the government doesn’t need to raise taxes or borrow in order to spend. For example, the former chief economist at the IMF, Olivier Blanchard, wrote in his macroeconomics text that the government
can also do something that neither you nor I can do. It can, in effect, finance the deficit by creating money. The reason for using the phrase ‘in effect,’ is that … governments do not create money; the central bank does. But with the central bank’s cooperation, the government can in effect finance itself by money creation. It can issue bonds and ask the central bank to buy them. The central bank then pays the government with money it creates, and the government in turn uses that money to finance the deficit.19
This option, which is also termed overt monetary financing (OMF), is erroneously referred to as ‘money printing’, a term that is used in a pejorative sense to put the policy option in a negative light. OMF is quickly dismissed and considered to be taboo because Blanchard, as with all mainstream economists, wrongly claims that it causes severe inflation. From a mainstream perspective, monetary financing is seen as a radical suggestion. From an MMT perspective, on the other hand, OMF is a desirable option that allows the currency issuer to maximise its impact on the economy in the most effective manner possible.
The idea is very simple and does not actually involve any printing presses at all: instead of selling debt to the private sector, the treasury simply sells it to the central bank, which then creates new funds in return. In this case, the bond purchases are explicitly aimed at an overt increase in the government’s fiscal deficit through expansionary policies, thus implying a cooperation between fiscal and monetary authorities; and they are subordinated to employment- and/or growth-related targets, as well as inflation targets. OMF does not carry any intrinsic inflationary risk: it is the government spending itself that carries such a risk, regardless of how such spending is financed – by raising taxes, issuing debt to the private sector or issuing debt to the central bank. Indeed, all spending (private or public) is inflationary if it drives nominal aggregate spending faster than the real capacity of the economy to absorb it.
What most people do not understand, however, is that sovereign governments could run fiscal deficits without issuing debt at all: the central bank could simply credit the relevant bank accounts to facilitate the spending requirements of the treasury, regardless of whether the fiscal position is deficit or surplus. In other words, OMF means that the government does not depend on the private bond markets to support its net spending (deficits). For a currency-issuing government, borrowing from the private sector is an accounting convention, not a necessity, and contributes nothing positive in terms of advancing the primary goals of such a government. Moreover, the issuance of treasury bonds effectively amounts to a form of corporate welfare for the purchasers, who tend to be financial institutions, wealthy individuals and foreign governments. Why should they enjoy a risk-free government annuity? This idea should become ingrained in the progressive mindset given the way that government debt is demonised by neoliberals and used as a pretext to impose fiscal austerity. The ability to spend without issuing debt is intrinsic to a currency-issuing government and the act of issuing bonds to the non-government sector is an unnecessary act.
Adair Turner, the former chair of the British Financial Services Authority, describes this form of monetary financing – which he considers to be ‘an always available and always effective option for stimulating nominal demand’ – as ‘running a fiscal deficit (or a higher deficit than would otherwise be the case) which is not financed by the issue of interest-bearing debt, but by an increase in the monetary base – i.e., of the irredeemable fiat non-interest-bearing monetary liabilities of the government/central bank’.20 OMF thus has the added benefit of flushing out a lot of debt-related paranoia, however unfounded it may be, since the deficit would not add to the overall debt.
To optimise the implementation of OMF, the central bank and treasury could (and should) effectively be ‘consolidated’ into a single government body. Technically, there is no need for one wing of the state (the central bank) to ‘lend’ money to another wing of the state (the government). However, it makes little difference from an operational perspective whether OMF is implemented in a non-consolidated fashion – that is, by getting the central bank to facilitate the government’s spending needs by underwriting government bonds or by directly crediting private bank accounts as instructed by the treasury, without the government offsetting this with bond-issuance – or in a consolidated fashion, by allowing the treasury to directly create new fiat money and credit the reserve accounts held by the commercial bank. In either case, this would make macroeconomic policy wholly accountable to voters instead of being managed by central bankers that are largely unaccountable and dominated by vested interests, as it is today. As we will argue in Chapter 9, democratic institutions need to assert their control over markets first and foremost through clear rules and regulations, but also to a certain extent by regaining the levers of economic, industrial and investment policy. A precondition for this is reclaiming a degree of democratic control over monetary policy itself.
Although most people would balk at the idea of OMF – because it is so removed from the current economic and monetary doctrine, especially in Europe – monetary financing is not a new idea. A number of well-known and diverse economists advocated similar policies as a response to the Great Depression in the 1930s. These include Harry Dexter White, Henry Simon, Irving Fisher, John Maynard Keynes and Milton Friedman. The idea was developed in the 1940s by the Russian-born British economist Abba Lerner, one of the forefathers of MMT. Lerner advocated that the government should ‘print money’ to match the government deficit spending needed to achieve and sustain full employment. In his seminal 1943 article, ‘Functional Finance and Federal Debt’, Lerner noted:
The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound or unsound. This principle of judging only by effects has been applied in many other fields of human activity, where it is known as the method of science opposed to scholasticism. The principle of judging fiscal measures by the way they work or function in the economy we may call Functional Finance. … Government should adjust its rates of expenditure and taxation such that total spending in the economy is neither more nor less than that which is sufficient to purchase the full employment level of output at current prices. If this means there is a deficit, greater borrowing, ‘printing money’, etc., then these things in themselves are neither good nor bad, they are simply the means to the desired ends of full employment and price stability.21
In 1948, none other than Milton Friedman argued not only that government deficits should sometimes be financed with fiat money, but that they should always be financed in that fashion, on the basis that such a system would provide a surer foundation for a low-inflation regime.22 Friedman used the term ‘helicopter drop’ to describe a situation where the government would print dollar bills and then use them to make a lump-sum payment to citizens – as if they had been dropped on the population from a helicopter flying above.23
The former US Federal Reserve chairman, Ben Bernanke, revived the idea of a ‘helicopter drop’ in 2002. In a speech to the National Economists Club in Washington about methods to avoid deflation, Bernanke advocated a ‘money-financed tax cut’, which he said was equivalent to Friedman’s anti-deflation proposal to drop money from helicopters in order to stimulate spending.24 Bernanke said that when total spending collapses, a nation endures rising unemployment and, ultimately, deflation, as ‘producers cut prices on an ongoing basis in order to find buyers’. As the recession deepens, interest rates drop to zero, which reduces the flexibility of monetary policy. Even from the conservative perspective of Ben Bernanke, these situations call for a significant increase in fiscal deficits to stimulate spending and confidence, with the central bank issuing new money to support the deficits. Bernanke reiterated his proposal in a recent article in which he called for a ‘Money-Financed Fiscal Program, or MFFP’, which he describes as a policy scenario in which the treasury simply instructs the central bank to credit bank accounts on its behalf (that is, without matching the fiscal deficit with debt issued to the non-government sector or central bank).25 He notes that this is an appealing idea because it would simulate the economy ‘even if existing government debt is already high and/or interest rates are zero or negative’. Since 2008, in reaction to the post-crisis global recession, the idea has been endorsed by a number of notable economists, including: Citigroup’s chief economist, William Buiter; Richard Wood; Martin Wolf; Paul McCulley and Zoltan Pozsar; Steve Keen; Ricardo Caballero; John Muellbauer; Paul Krugman, and others. Though most authors view monetary financing as a way to finance the government deficit directly, others have suggested using OMF to inject new money directly into citizens’ bank accounts, bypassing the government altogether.
Even though historical data on monetary financing is somewhat limited, there are a number of case studies that illustrate the positive effects of OMF. Various analyses show that in the 1930s Japanese finance minister Korekiyo Takahashi was able to jump-start the Japanese economy by allowing the central bank to create money to fund public works. Korekiyo is famous for abandoning the gold standard in 1931 and introducing a major fiscal stimulus with central bank credit that ‘was found to have been crucial in ending the depression quickly’.26 Ellen Brown has demonstrated how the German government used its currency-issuing powers to finance public investment from 1933 to 1937, transforming a bankrupt country into the strongest European economy in just four years.27 While Ryan-Collins and others have shown that OMF was critical to the economic development of Canada (1935–71) and New Zealand (1935–9).28
The main argument against OMF, and expansionary monetary and fiscal policies in general, is that they inevitably lead to inflation – or hyperinflation, in the case of OMF. However, there is no reason to believe that a monetary financing programme would inevitably result in excessive inflation, let alone hyperinflation. The oft-quoted hyperinflation examples – such as 1920s Germany and modern-day Zimbabwe – do not support the claim that monetary financing and/or large government deficits cause inflation. In both cases, there were major reductions in the supply capacity of the economy prior to the inflation episode. As already mentioned, there is no inherent technical reason to believe that OMF would be more inflationary than any other policy stimulus, or that it would produce hyperinflation, since the impact on nominal spending and thus potentially on inflation depends entirely on the scale of the operation: there is no risk of hyperinflation as long as the total spending growth in the economy does not exceed the productive capacity of the economy. In the context of the legitimate goals of a currency-issuing government, OMF would facilitate sufficient net spending to allow the economy to sustain full employment, which means that it would be irrational for such a government to push spending beyond that productive limit deliberately.
Moreover, it is often overlooked that the current system allows private banks to create most of the digital money in circulation through loans, which create deposits and liquidity that can be spent. This freedom gives banks the power to engineer credit-driven booms at will, which in turn leads to soaring prices (especially in the housing market). When these booms inevitably go bust, triggering a crisis, the banks attempt to repair their overleveraged balance sheets by engaging in excessive deleveraging, cutting off credit when households and businesses need it the most. This exacerbates the crisis and drives the economy into what economist Richard Koo described as a ‘balance sheet recession’.29 When this happens, fiscal deficits are required for extended periods of time at elevated levels to provide the spending support to allow the non-government sector to reduce the precariousness of their balance sheet position – that is, to reduce their indebtedness. That debt-reduction process is lengthy and results in lower than normal non-government spending and the risk of extended recession unless spending is supported by higher-than-normal government deficits.
If currency-issuing governments are so free of financial constraints, then why do they continue to tax and to issue debt? While there are legitimate reasons for governments to raise taxes and issue debt – which are, however, different from the ones claimed by mainstream economists and policymakers, as we shall see – a simple answer is that most currency-issuing governments continue to impose voluntary constraints on themselves that resemble the spending constraints that existed under the gold standard. These ideologically motivated fiscal rules – which resemble other forms of voluntary constraints that we have analysed in previous chapters – are designed to limit the capacity of government to run deficits and/or borrow from the central bank and non-government sector. As we have seen, the two main voluntary, operational rules which are typical of many countries are: (i) the treasury must have sufficient deposits in its account at the central bank before it can spend; and (ii) if the treasury does not have sufficient deposits to cover mandated spending, it must issue bonds to ‘finance’ the deficit. Moreover, it cannot sell the newly issued bonds to the central bank on the primary market; it must sell them to private banks or other investors. However, the central bank can buy these bonds on the secondary market. In various countries, this goes hand in hand with ‘debt ceilings’ of various kinds – legislative limits on the amount of national debt that can be issued.
From a financing perspective, none of these complex accounting structures are necessary. However, governments continue to employ them to obfuscate the way government spending actually works and thus to rationalise the imposition of neoliberal fiscal policies. Politicians know that rising public debt can be politically manipulated and demonised in order to get citizens and workers to accept – demand even – policies that are not in their class interest. Similarly, taxation – needed, it is claimed, to ‘finance’ government spending – can also be (and often is) used for political ends, such as transferring wealth from the lower-middle classes to the upper classes. Nonetheless, these rules could be legislated out of existence if the public truly understood how the monetary system operates. Similarly, the EMU is itself a system of voluntary constraints that are reflected in legal statements, all of which could be changed via appropriate legislation. In this regard, MMT exposes the notion of voluntary versus intrinsic constraints in a fiat currency system, thus lifting the veil of ideology in the same way that Marx exposed the superficial exchange relations that overlay the production of surplus value and the essence of private profit.
That said, there are good reasons why a currency-issuing government may choose to issue debt or raise taxes. In regard to the former, debt issuance can serve an interest-maintenance function by providing investors with an interest-bearing asset that drains the excess reserves in the banking system that result from deficit spending. If these reserves were not drained (that is, if the government did not borrow) then the spending would still occur but the overnight interest rate would plunge (due to competition by banks to rid themselves of the non-profitable reserves), and this may not be consistent with the stated intention of the central bank to maintain a particular target interest rate. In this context, if the central bank desires to maintain the current target cash rate, then it must provide an alternative to this surplus liquidity by selling government debt. In other words, from an MMT perspective, bond sales by sovereign governments should be seen as an aspect of monetary policy, not as a source of funds to finance government spending. However, as has become evident in the period since the financial crisis, central banks can achieve the same outcome by paying a return on excess reserves. It does not have to offer debt to the banks – in so-called open market operations – to maintain a positive target interest rate. When we understand these points, it becomes clear that the issuing of debt and the payment of interest income is identical in impact as the central bank paying interest on excess bank reserves.
We have also seen that a sovereign government doesn’t really need revenue in its own currency to spend. Some who hear this for the first time jump to the question: ‘Well, why not just eliminate taxes altogether?’ There are several reasons. First, it is the tax that drives the currency. If we eliminated the tax, people probably would not immediately abandon use of the currency, but the main driver for its use would be gone. The imposition of a tax obligation denominated in the currency of the government creates an immediate demand for that currency and a desire to transfers goods and services (including labour) from the non-government sector to the government sector, in order to get hold of the currency. The second reason to have taxes is that it provides the government with a capacity to manage non-government spending to ensure price stability. Taxes create real resource space – that is, free up real resources in the economy (labour and capital), which otherwise would have been used by the non-government sector for private ends – because the non-government sector is deprived of purchasing power. This ‘space’ is what MMT calls ‘fiscal space’, and it allows the government the non-inflationary access to real resources necessary for it to fulfil its socio-economic mandate. It stands in contradistinction with the neoliberal view of fiscal space, which erroneously assumes that the government can run out of money. Other reasons for raising taxes, of course, include redistributing wealth – for example, to avoid excessive concentration of wealth in the hands of the upper classes – and encouraging (or discouraging) certain industries and/or products (for example, taxes on alcohol or carbon taxes). None of these, however, have anything to do with the funding of government spending, at least as far as currency-issuing governments are concerned.
Tax revenue also tends to moves counter-cyclically – increasing in an expansion and falling in a recession. This creates an in-built or automatic stabiliser capacity within fiscal policy that attenuates the impact of sudden shifts in non-government spending. To understand this, let us imagine that non-government spending contracts sharply due to a wave of pessimism about the future. Production is cut back and employment falters. The lost tax revenue (and the increased demand for income support) pushes the government’s fiscal position towards a deficit (if starting from a surplus) or a higher deficit (if already in deficit), which underpins (provides a floor) in total spending in the economy, without the government changing any discretionary policy settings. So this counter-cyclical nature of tax receipts helps to make the government’s net contribution to the economy counter-cyclical, which, in turn, helps to stabilise aggregate demand. Ultimately, tax rates should be set so that the government’s fiscal outcome (whether in deficit, balanced or in surplus) is consistent with full employment.
As mentioned, this does not imply that a currency-issuing government should spend or incur deficits without limits, or that fiscal deficits are desirable per se. Fiscal deficits ‘in themselves are neither good nor bad’, as Abba Lerner wrote.30 Any assessment of the fiscal position of a nation must be taken in the light of the usefulness of the government’s spending programme in achieving its national socio-economic goals. This is what Lerner called the ‘functional finance’ approach. Rather than adopting some desired fiscal outcome (such as achieving fiscal surpluses at all costs), governments ought to spend and tax with a view to achieving ‘functionally’ defined outcomes, such as full employment. Fiscal policy positions thus can only be reasonably assessed in the context of these macroeconomic policy goals. Attempting to assess the fiscal outcome strictly in terms of some prior fiscal rule (such as a deficit of 3 per cent of GDP) independent of the actual economic context is likely to lead to flawed policy choices. Thus, from a progressive standpoint – that is, one that assumes the government’s objective to be the pursuit of full employment and increased levels of well-being of its citizens – there might indeed be circumstances in which it is sound for a government to run a fiscal surplus, though more often than not ongoing fiscal deficits will be required. To appreciate this point, we need to understand the sectoral balances (or flow of funds) approach to macroeconomics as developed by the British economist Wynne Godley.
Macroeconomists simplify the myriad transactions and relationships that comprise a socio-economic system by focusing on broad sectors, which aggregate all these transactions. If, for simplicity’s sake, we split the economy into two sectors – government and non-government – then the impact of fiscal deficits and surpluses can be seen more clearly. The former is comprised of the central bank and treasury, while the latter encompasses households, firms and private banks (we will leave the rest of the world, that is, the external or foreign sector, out of our analysis for the moment). A very simple example of such an economy, which captures the essence of the relationship between the government and non-government sectors, is an economy with a population of just two: one person being government and the other being the non-government sector. If the government runs a balanced fiscal position (spends 100 and taxes 100 dollars) then non-government accumulation of fiat currency (money) is zero in that period and the non-government budget is also balanced. Thus, there is no non-government saving in the currency. Let’s say the government spends 120 and taxes remain at 100, then the non-government surplus is 20, which can accumulate as financial (monetary) assets. This represents an increase in the non-government sector’s net worth or wealth. The non-government saving of 20 initially takes the form of non-interest-bearing money holdings. The government may decide to issue an interest-bearing bond to encourage saving but operationally it does not have to do this to finance its deficit, as we have seen. An interest-bearing bond is just a piece of paper that says the government will repay a certain amount (the face value) at some specified time (maturity date) and will pay an interest premium in addition (the yield or coupon rate). The non-government sector exchanges cash for the bond if it wants to earn interest and has no use for the liquid funds, which may be held as deposits in private banks. The government deficit of 20 is exactly the non-government savings of 20. Now, if the government continued in this vein, accumulated non-government savings would equal the cumulative fiscal deficits. However, should the government decide to run a surplus (say, spend 80 and tax 100) then the non-government sector would owe the government a net tax payment of 20 and would need to run down its prior savings, sell interest-bearing bonds back to the government or run into debt to get the needed funds.
Either way, the accumulated non-government saving (financial wealth) is reduced when there is a government surplus – that is, when the government spends less than it withdraws via taxation. Thus, contrary to neoliberal rhetoric, the systematic pursuit of government fiscal surpluses is necessarily manifested as a systematic decline in non-government sector savings. The government surplus thus has two negative effects on the non-government sector: (i) the stock of financial assets (money or bonds) held by the non-government sector, which represents its wealth, falls; and (ii) non-government disposable income also falls in line with the net taxation impost. Some may retort that government bond purchases provide the non-government wealth-holder with cash. That is true, but the fiscal surplus forces the non-government sector to liquidate its wealth to resolve its shortage of cash that arises from the tax demands exceeding current income. The cash from the bond sales pays the government’s net tax bill. The result is exactly the same when expanding this example by allowing for non-government income generation, private firms and production, and a banking sector. In other words, the national government deficit (surplus) equals the non-government surplus (deficit). It should furthermore be noted that, precisely because of the intrinsic relationship between the government and non-government sector, the fiscal outcome is largely beyond the control of government. For example, if private domestic spending is weak then the fiscal deficit will typically rise as tax revenue declines, irrespective of what government does, and vice versa. The failure to recognise this relationship is a major oversight of mainstream economic analysis.
There is another important aspect of the relationship between the government and non-government sectors that is often misunderstood but crucial to understanding the suite of options available to a currency-issuing government. In any monetary system there are financial assets and liabilities. These are specified in monetary terms and can take a multitude of forms. A financial asset could be a bank deposit, some money in your pocket, a government bond or a corporate bond. A financial asset is different from a real asset, such as property holdings or a work of art, because it has no tangible expression. For example, a bank deposit is a virtual statement of wealth. A financial liability is usually a bank loan or some other debt that is owed. The difference between total financial assets and total financial liabilities is called net financial assets. It is different to total net wealth or net worth in that it excludes real assets.
Financial transactions within the non-government sector cannot create new net financial assets or destroy previous net financial positions. For example, when a bank agrees to a loan it creates a deposit that the borrower can draw upon to fund spending. The loan is an asset to the bank but also an equal and offsetting liability for the borrower. There is no net gain in financial assets for the non-government sector as a whole from this transaction. Transactions within the non-government sector may alter who owns the financial assets and the form those assets are held in, but they do not alter the net position of that sector overall. For example, a household might use some cash it holds in a bank deposit to purchase a corporate bond. The person’s financial asset is now a bond rather than cash and the liability shifts from the bank to the corporation that has borrowed the funds. But there is still the same quantity of assets and liabilities in the non-government sector overall.
For the non-government sector to accumulate net financial assets (financial wealth) or lose net financial assets, there has to be a source of financial assets that is ‘outside’ the non-government sector. This can only be the government sector. In this context, MMT considers the government sector to be the consolidation of the treasury function (fiscal policy) and the central bank (monetary policy). Even though this does not reflect the reality of most countries, as we have seen, consolidating the currency-issuing arm of government (central bank) and the spending and taxing arm (treasury) allows for a better understanding of how net financial assets can enter and exit the non-government sector. It is the transactions that are conducted between the consolidated government sector and the non-government sector which determine the level of net financial assets (denominated in the national currency) that are held by the non-government sector.
Only these transactions can create or destroy net financial assets in the non-government sector. In our simple two-person economy, the fundamental principle is that the non-government sector can only accumulate net financial assets if the government runs a fiscal deficit. We can now more fully appreciate that result. For example, when the treasury department purchases some equipment for a school, it will instruct the central bank to put funds into the bank account of the private supplier of the equipment. The bank entry is created because the government required it to be created. In effect, the entry was created out of thin air, notwithstanding the ‘accounting’ arrangements discussed earlier that make it look as if the funds were generated by, say, tax revenue. The private supplier now has a higher bank account balance (an increased asset) but there is no offsetting liability within the non-government sector. Net financial assets have increased in that sector as a result of the government spending.
Conversely, when the government extracts tax revenue from the non-government sector, the taxpayer will, depending on the arrangements within the tax system, see more income extracted from its pay cheque or an existing bank deposit reduced by the amount of the tax liability. Either way, financial assets decline in the non-government sector without any corresponding decline in liabilities. As a result, net financial assets decrease. These transactions occur every day, and if the government spends more than it receives by way of tax revenue (a deficit) then net financial assets in the non-government sector will rise. The main thing to keep in mind about taxes is that they reduce liquidity in the private sector. Fiscal deficits increase the financial wealth of the non-government sector. Fiscal surpluses, clearly, have the opposite effect: they destroy net financial assets and financial wealth in the non-government sector. So, when conservatives and misguided progressives call for deficit reduction and a shift to fiscal surplus, what they are really calling for, probably unwittingly, is the reduction in non-government financial assets – our wealth.
We are now able to understand how mass unemployment arises and why government is central to its solution. There is no unemployment in traditional non-monetary economies or in non-monetary segments of a modern economy. For example, an unpaid childcarer can never be unemployed. In monetary economies, however, the output of goods and services responds to spending. Firms and other organisations do not produce if they are not confident of selling their output. The production process generates a flow of income (paid to the various production inputs). One person’s spending is another person’s income. A basic macroeconomic rule is that total spending must equal total income for all the goods and services produced in any period to be sold. If total spending in a period is less than the total income generated, then firms will have unsold output in the form of unwanted inventory accumulation and will reduce future production and employment.
Why would total spending fall below total income in any period? A simple reason might be that households desire to save some of their income for future use or to purchase imports, which means income generated in the domestic economy is spent abroad. The result of this spending deficiency is a rise in involuntary unemployment, which is idle labour offered for sale with no buyers at current wages. In this situation, making labour cheaper (cutting wages) will not reduce unemployment, unless those cuts somehow increase total spending. Clearly, wages are an important component of total income and spending is dependent on income. Cutting wages is thus likely to worsen a spending shortfall.
In our simplified two-sector economy, if the non-government sector desires to save overall, it will spend less than its income. That shortfall in each period has to be eliminated by the government spending more than it receives in revenue (that is, running a fiscal deficit) to prevent a rise in mass unemployment. There is another complication. The non-government sector may desire to save overall but it also has to pay taxes from its income, which further reduces the amount that can be recycled back into the non-government spending stream in each period. The imposition of taxation thus reduces the spending power of the non-government sector. That gap also has to be filled by government spending, which means ‘taxes in aggregate will have to be less than total government spending’.31
Therefore, if the objective is to maintain full employment, while there may indeed be circumstances that require a fiscal surplus (for example, if private sector spending is strong or if the country is running a large current account surplus), for most countries this will typically require continuous fiscal deficits of varying proportions of GDP as the overall saving desires of the private domestic sector vary over time. By the same token, unemployment occurs when net government spending is too low relative to the current tax receipts, or taxes are too high relative to the level of government spending, after taking into account the overall saving desires by the non-government sector that have to be matched by government deficits.
There is a parable that allows us to understand better the relationship between the government and non-government sector. Imagine a small community comprising 100 dogs. Each morning they set off into the field to dig for bones. If there are enough bones for all the dogs buried in the field then they would each succeed in their search no matter how fast or dexterous they were. Now imagine that one day the 100 dogs set off for the field as usual, but this time they find there are only 90 bones buried. As a matter of accounting, at least ten dogs will return home bone-less. Now imagine that the government decides that this is unsustainable and decides that it is the skills and motivation of the bone-less dogs that is the problem. They are not skilled enough. They are idlers, skivers and just need to ‘bone-seek’ harder. So, a range of dog psychologists and dog trainers are called in to work on the attitudes and skills of the bone-less dogs. The dogs undergo assessment and are assigned case managers. They are told that unless they undergo training they will miss out on their nightly bowl of food that the government provides to them while bone-less. They feel despondent. Anyway, after running and digging skills are imparted to the bone-less dogs, things start to change. Each day, as the 100 dogs go in search of 90 bones, we start to observe different dogs coming back bone-less. The composition of the bone-less queue changes. However, on any particular day, there are still 100 dogs running into the field and only 90 bones buried there. At least ten dogs will always return bone-less. The only way for all dogs to get a bone is for the government to increase the number of bones.
The conclusion that mass unemployment is the result of the government deficit being too low also defines the limits on responsible government spending. It is clear that government spending has to be sufficient to allow taxes to be paid. In addition, net government spending is required to meet the non-government desire to save (accumulate net financial assets). The government should aim to maintain total spending such that firms are willing to produce and employ at levels sufficient to engage the available labour resources fully. Not a penny more need be spent by government. This logic also allows us to see why the pursuit of government fiscal surpluses will be contractionary. Pursuing fiscal surpluses is necessarily equivalent to the pursuit of non-government sector deficits. They are two sides of the same coin. For a time, inadequate government deficits can continue without rising unemployment. In these situations, as is evidenced in many countries in the pre-crisis period, GDP growth can be driven by an expansion in private debt. The problem with this strategy is that when the private debt-service levels reach some threshold percentage of income, the private sector will ‘run out of borrowing capacity’ as incomes limit debt service and banks become risk-averse. Typically, this will then provoke efforts to reduce the debt exposure (a so-called ‘balance sheet restructuring’) and render the household and/or firm finances less precarious. As a consequence, total spending from private debt expansion slows and unemployment rises unless the government increases its deficit. If the government refuses to show fiscal leadership then recession follows. In other words, in some circumstances credit finance can indeed expand to accommodate growth in the private sector in the presence of insufficient fiscal deficits, but this growth will be inherently unstable. Only fiscal deficits can provide the foundation for stable growth and employment.
Things get a little more complicated when we consider that the non-government sector in an open economy is not just composed of the private domestic sector. We must add the impact of the external sector (sometimes referred to as the rest of the world). We should thus understand modern economies as being composed of three sectors: the government (or public) sector, the private domestic sector and the foreign (or external) sector. This last sector represents the portion of a country’s economy that interacts with the economies of other countries, and is thus the one that influences the country’s current account balance (a broad measure of the balance of trade). In this model, the government sector’s deficit (surplus) is still equal to the non-government sector’s surplus (deficit). Except that we now say that the government sector’s deficit (surplus) is equal to the private domestic sector’s surplus (deficit) plus the current account balance. That is because, in an open economy, the net income of the private domestic sector is composed by the government deficit and the current account surplus (if there is one).
Therefore, in the presence of an external deficit – that is, if the country imports more than it exports – the government balance necessarily has to be in deficit for the private domestic sector to be in surplus – that is, for the private domestic sector to be able to save overall. By the same token, in the presence of an external deficit and a simultaneous government surplus, the private domestic sector must necessarily run a deficit, that is, dis-save or spend more than it earns. Under these conditions, private spending can persist for a time only if the private domestic sector accumulates ever-increasing levels of debt. This, however, will eventually become unsustainable and lead to a financial crisis. Moreover, as surpluses destroy net financial assets, this increase in private sector debt will be matched by a continuous decline in its net financial assets or wealth. On the other hand, in the presence of a current account surplus – that is, if the country exports more than it imports – the private domestic sector may able to net save even in the presence of a government surplus. Thus, in an open economy, the correct discretionary fiscal stance can only be determined by taking into account the current account balance (the rest of the world’s desire to save/dis-save) as well as the private domestic sector’s desire to save/dis-save. However, just like in our simplified two-sector model, we should understand that the fiscal outcome for a currency-issuing government is largely residual, rising when private domestic and foreign demand shrinks and falling when demand is rising. By the same token, a nation’s current account deficit is largely a function of the rest of the world’s desire to spend.
For example, let us assume that the external or foreign balance equals zero. Let us further assume that the private domestic sector’s income is 100 while its spending is equal to 90, which delivers an overall surplus of ten over the year. The government sector’s fiscal deficit for the year must be equal to ten as a consequence of the national accounting conventions that tie these three sector balances together. We know that the private domestic sector will accumulate ten currency units of net financial wealth during the year, consisting of ten units of domestic government sector liabilities (given that the external balance is zero). As another example, let us assume that the foreign sector spends less in the nation in question relative to the income it receives from that nation (via exports and/or net income transfers), which generates a current account deficit of 20 in the nation in question. At the same time, the government sector also spends less than its income, running a fiscal surplus of ten. From our sectoral balances accounting identity, we know that over the same period the private domestic sector must have run an overall deficit equal to 30 (20 plus 10). At the same time, its net financial wealth will have fallen by 30 units as it sold assets and/or issued debt. Meanwhile, the government sector will have reduced its outstanding debt or increased its claims on the other sectors by ten, and the foreign sector will have reduced its net financial position by 20 (also raising its outstanding debt or reducing its claims on the other sectors). Given a current account deficit of 20, the only way for the private domestic sector to run a surplus – that is, to net save – over the year is for the government sector to run a deficit higher than 20.
It is apparent that it is impossible for all sectors to run surpluses (that is, to ‘save overall’ – spend less than their income) simultaneously. That is, it is impossible, over any given period of time, for all sectors to accumulate net financial wealth by running surpluses. For one sector to run a surplus (in the example offered above, the government) at least one other sector (in this case the private sector) must run a deficit. To put it differently, if one sector spends more than its income, at least one of the others must spend less than its income because, for the economy as a whole, total spending must equal total receipts or income. While there is no reason why any one sector must run a balanced position (spending equal to income), the sectoral balances framework shows that the system as a whole must.
Often, but not always, the private domestic sector tends to run a surplus – spending less than its income. This is how it accumulates net financial wealth. Overall private domestic sector saving (or surplus) is a leakage from the overall expenditure cycle that must be matched by an injection of spending from another sector. The current account deficit (the so-called external sector account) is another leakage that drains domestic demand. That is, the domestic economy is spending more overseas than foreigners are spending in the domestic economy. Thus, in the presence of a private sector surplus, demand must either come from the external sector, in the form of a surplus, or from the government, in the form of a fiscal deficit. Similarly, in the presence of an external deficit, in order for households and firms together (that is, the private domestic sector) to run a surplus it is necessary for the government to run a deficit.
The accounting structures that underpin the sectoral balances framework thus allow us to test the logic of statements made by policymakers. For example, if a politician says that the government and non-government sectors should simultaneously reduce their net indebtedness (increase their net wealth), assuming neoliberal public debt issuance strategies, we know that the statement is an accounting impossibility, unless the country is running a very large current account surplus. We don’t have to resort to theory to reach such a conclusion.
An analysis of the sectoral balances of the US and Japan over the past two decades can help to better understand this point. Wynne Godley and Alex Izurieta, for example, have shown the adverse consequences (for other sectoral balances) that resulted from the dramatic shift in the US federal government’s fiscal balance over the 1992–2000 period, from borrowing levels of 6 per cent of GDP to a budget surplus of over 1.5 per cent of GDP in 2000.32 As a result, given that the country registered a constant current account deficit during the same period, the private sector’s saving levels inevitably plummeted, while its debt levels increased dramatically. As the government surplus began to diminish after 2000, private sector debt levels began to recover, although the situation began to deteriorate once again after 2003. In contrast, Japan’s experience over the same period shows that the private sector surplus increased on a par with the long-term increase in the fiscal deficit. In other words, persistent and substantial fiscal deficits (along with a modest current account surplus) financed the saving desires of the private sector and helped to maintain positive levels of real activity in the economy. These relationships demonstrate the strength of fiscal policy to underwrite economic activity.
In the real world, of course, the correct discretionary fiscal stance also depends on the underlying economic structure of any given country – that is, on the relative weight of the export sector. Nations that will typically have a current account deficit at full employment (such as Australia, the US and the UK) will normally have a fiscal deficit at full employment (equal to the sum of the current account deficit and the domestic private sector surplus). Countries like Japan (with a modest current account surplus at full employment) will have a relatively smaller fiscal deficit at full employment (equal to the domestic private sector surplus minus the current account surplus). Countries with larger current account surpluses at full employment, such as Norway, will typically have a fiscal surplus at full employment, so as not to push the economy past the inflation barrier.
We have thus limited ourselves to identifying an accounting relationship between the various sectoral balances. However, this says little about the causal relationships between the flows of income and expenditure and the impact on the stocks of the various sectors. Now, it is a basic fact of economics that spending is mostly determined by income. It is thus fairly straightforward to assume that in an open economy deficit spending by the government – because it raises the income of the private sector (particularly if the spending is aimed at attaining and maintaining full employment) and because a portion of that income is likely to be spent on foreign goods and services – will lead to a smaller current account surplus (if the country has one) or, as is most often the case, a (larger) current account deficit. This basic economic reality is usually used – by mainstream as well as, alas, left commentators and politicians – to disprove the notion that governments can use fiscal stimulus to achieve and sustain full employment and the overall well-being of the citizenry. The underlying assumption is that sustained current account deficits are intrinsically bad and unsustainable, since they will inevitably push the nation in question into a balance-of-payments crisis, which, in turn, will require it to adopt painful recessionary measures to compress internal demand, reduce imports and bring the country back into current account (balance-of-payments) equilibrium. This argument – known as the balance-of-payments constraint – is used to suggest that full employment and domestic income growth (which, as we have seen, usually requires sustained fiscal deficits), and progressive policies more generally, are possible only insofar as the country maintains a balance-of-payments equilibrium, that is, if exports are more or less matched by imports. So-called progressive economists, in particular, are enamoured with the idea that MMT is flawed because it doesn’t recognise the fiscal limits imposed by the need to maintain a stable external balance. In the following section, we will clarify why the notion that monetarily sovereign governments that float their currency face a balance-of-payments constraint is just as unfounded as the notion that they face a solvency constraint.
Steve Suranovic, associate professor of economics and international affairs at the George Washington University, notes that one of the most popular and pervasive myths about international trade, ‘simply stated, is that trade deficits are bad and trade surpluses are good’:
The presence of a trade deficit, or an increase in the trade deficit in a previous month or quarter, is commonly reported as a sign of distress. Similarly, a decrease in a trade deficit, or the presence of or increase in a trade surplus, is commonly viewed as a sign of strength in an economy.33
However, Suranovic writes,
these perceptions and beliefs are somewhat misguided. In general, it is simply not true that a trade deficit is a sign of a weak economy and a trade surplus is a sign of a strong economy. Merely knowing that a country has a trade deficit, or that a trade deficit is rising, is not enough information to say anything about the current or future prospects for a country – and yet that is precisely how the statistics are often reported.34
There are two main reasons why trade deficits are considered deleterious: (i) because they are considered to result in the loss of domestic jobs, due to domestic income being spent on foreign firms’ goods/services rather than domestic firms’ goods/services, and thus to compromise the long-term growth prospects and welfare of a nation; and (ii) because, as mentioned, they are considered to lead inexorably to balance-of-payments crises, that is, given that current account deficits are necessarily associated with an increase in the country’s level of foreign debt, it is assumed that large and persistent trade deficits will require a significant fall in living standards when the loans finally come due. As we will see, both arguments are largely unfounded.
Let us first look at the claim that trade deficits lead to job losses. A first point to acknowledge is that a trade deficit on the current account necessarily has to be matched by an equal and opposite net financial inflow on the capital (or financial) account, representing an increase in foreign claims against the country in question. That is because a current account deficit necessarily needs to be financed with capital inflows from abroad. This means that foreigners – usually those residing in countries that run a trade surplus on the current account, which necessarily has to be matched by an equal and opposite net financial outflow on the capital account – are purchasing domestic financial (or other) assets denominated in the deficit country’s currency of issue, either by lending money to the country’s citizens and/or government or by purchasing equities such as stocks and real estate. Thus, the capacity of a nation to run a current account deficit on an ongoing basis of any size is reliant on the desire of foreigners to accumulate financial claims in the currency issued by that nation. In this sense, from a MMT perspective, a current account deficit signifies the willingness of foreigners to ‘finance’ the saving desires of the deficit country’s foreign sector. In other words, current account deficits and surpluses can only be understood in relational terms: since the current account of the world as a whole must necessarily be in balance in each period (until we figure out a way to export to other planets), it follows that for some countries to run current account surpluses others must be willing to run current account deficits (financed by the former), and vice versa. Surpluses and deficits are consequently two sides of the same coin: it is economically impossible for all countries to be in surplus at the same time. In fact, when countries that trade with each other attempt to run surpluses at the same time, this usually leads to trade wars (which historically have been the prelude to all-out military conflicts).
In any case, the money flowing into the deficit country is ultimately spent by someone and ‘[w]hen it is spent, it creates demands for goods and services that in turn create jobs in those industries’.35 Thus, while it is legitimate to assume that a trade deficit will lead to job losses in the export sector, there is no reason to believe that it will lead to an overall loss of jobs at the aggregate level. In fact, evidence from various countries points to the contrary, with the unemployment rate falling as the trade deficit rises, and vice versa.36 Moreover, the ‘trade deficits cause job losses’ narrative ignores a crucial point: not only can the government always support domestic demand and thus maintain positive levels of real activity in the economy even in the face of an external spending drain resulting from a current account deficit; it can also always compensate any job losses in the private sector by directly employing any idle labour for sale in the currency of issue, thus ensuring full employment, as we discuss in more detail in Chapter 9.
Ultimately, however, whether trade deficits depress domestic demand or not, and to what degree, is a moot point. As mentioned, the causality usually works in reverse, with increased domestic consumption leading to (larger) current account deficits. Jobs aside, is this a problem for the country’s overall welfare? To answer this question, we first have to define what we mean by ‘national welfare’. As Suranovic notes, in materialistic terms this is ‘best measured by the amount of goods and services that are “consumed” by households’: in other words, ‘the standard of living obtainable by the average citizen’ is ‘affected not by how much the nation produces but by how much it consumes’.37 Whether the goods consumed are domestically produced or imported makes little difference from the perspective of the domestic citizens, since they add to their well-being and standard of living in equal measure. It thus follows that a current account deficit – which corresponds to higher consumption than would be possible under conditions of trade equilibrium or surplus – raises the material welfare of a nation in the period in which it occurs. This holds particularly true for developing countries, which often lack the real resources (such as best-practice technology) necessary to fuel industrialisation and productive capacity. As even the IMF acknowledges, for these countries a trade deficit may be the only way to raise average living standards.38
Conversely, a current account surplus – which corresponds to lower goods and services (both domestic and foreign) being consumed domestically than would be possible under conditions of trade equilibrium or surplus, usually as a result of demand-compressing (that is, mercantilist) policies (low wages and/or government spending) – reduces the material welfare of a nation in the period in which it occurs. As Suranovic writes:
The excess of exports over imports represents goods that could have been used for domestic consumption, investment, and government spending but are instead being consumed by foreigners. This means that a current account surplus reduces a country’s potential for consumption and investment below what is achievable in balanced trade. If the trade surplus substitutes for domestic consumption and government spending, then the trade surplus will reduce the country’s average standard of living. If the trade surplus substitutes for domestic investment, average living standards would not be affected, but the potential for future growth can be reduced. In this sense, trade surpluses can be viewed as a sign of weakness for an economy, especially in the short run during the periods when surpluses are run. Surpluses can reduce living standards and the potential for future growth.39
Germany provides a good case in point. Even though the country is often touted as a success – and as a model for other countries to follow – for its massive current account surplus, in his book Die Deutschland Illusion, Marcel Fratzscher, head of the German Institute for Economic Research (DIW), writes that Germany’s obsession for trade surpluses has resulted in chronic private underinvestment in the country’s economy, as the whole system depends on German capital fuelling demand abroad.40 This has caused private investment to fall from 22.3 per cent of GDP in 2000 to 18 per cent in 2016, less than most comparably rich countries, which – combined with one of the lowest levels of gross government investment in Europe – is responsible for low productivity growth (because it discourages workers from upgrading skills and companies from investing in higher-value production) and for what a Spiegel article described as ‘Germany’s ailing infrastructure’, with highways, bridges and even the Kiel Canal in desperate need of maintenance.41 According to DIW calculations, the investment shortfall between 1999 and 2012 amounted to about 3 per cent of GDP, the largest ‘investment gap’ of any European country.42 Furthermore, Germany’s current account surplus is largely a result of the wage-compressing policies pursued by the government from the mid-2000s onwards, which led to a proliferation of precarious, low-paid, low-skilled jobs, and to the stifling of internal demand – and thus of imports. German citizens have therefore experienced – and continue to experience – considerably lower living standards than they would have enjoyed under conditions of trade equilibrium or surplus. As Philippe Legrain wrote, this demonstrates that Germany’s external surpluses, far from being an example of superior competitiveness, ‘are in fact symptomatic of an ailing economy’.43
We are thus in a position to appreciate MMT’s claim that exports represent real costs for the surplus nation, while imports represent real benefits for the deficit nation. This notion is based on the distinction between real resources measured in accumulated goods and services and nominal wealth measured in accumulated financial credits. Exports represent real resources being denied to the country’s citizens and sent to other nations, in return for nominal wealth received from them (financial credits), while imports represent real resources being received from other nations, in return for nominal wealth. In this sense, the oft-heard claim that deficit countries are ‘living beyond their means’ makes little sense; if anything, it is the surplus countries that are ‘living below their means’. Ultimately, the question is whether a country prefers to ship fiat money abroad in exchange for goods and services or to ship goods and services abroad in exchange for fiat money.
The mainstream response to this is that trade deficits – regardless of whether they are beneficial or not to the deficit country in the period in which they occur – are inherently unsustainable in the long run, because an excessive accumulation of foreign debt will eventually precipitate a balance-of-payments crisis, as the country will find itself unable to service its growing level of foreign debt or will be subject to a sudden outflow of capital, as international capital markets lose confidence in the nation’s ability to service the debt. This will force a contraction in demand and a severe depreciation of the currency, causing a significant fall in living standards. In turn, the government will be forced to adopt recessionary policies (including higher interest rates to attract capital inflows) that reduce the growth rate (and therefore imports) and push up the unemployment rate. It is only once the country’s balance-of-payments position has come back into balance or surplus that the nation will regain access to international capital markets. It is therefore claimed that countries should eschew running current account deficits to avoid the painful rebalancing that will inevitably be required. The argument is persuasive because there is an element of truth to it. However, as we will see, it is another example of applying outdated gold standard logic to the radically different world of fiat currency systems with floating exchange rates.44
As we saw, under the Bretton Woods system of fixed exchange rates, where the central bank had to manage its foreign currency reserves to maintain the agreed parity with other currencies, the balance of payments was indeed a constraining influence on real GDP growth. In this situation, a nation could not run persistent external deficits because it would soon run out of the foreign currency reserves and/or gold stock that were necessary to defend the parity. That is one of the reasons why the system broke down. External deficit nations were forced to suppress domestic demand via higher interest rates, fiscal austerity and/or wage compression both to reduce imports and/or attract capital inflows to alleviate their balance-of-payments problems. The result was that these countries were prone to extended periods of mass unemployment, which were politically unsustainable. The same applies today to countries that peg their currency to foreign currencies (usually the US dollar).
In a flexible exchange rate system, however, no such constraints exist. Under such a system, the mainstream claim that ‘a country cannot go on borrowing indefinitely’ makes little sense – and is in fact constantly defied by reality. As noted above, a current account deficit reflects the fact that a country is building up liabilities to the rest of the world that are reflected in net financial inflows on the capital account. While it is commonly believed that these must eventually be paid back, this is obviously false. As the global economy grows, there is no reason to believe that the rest of the world’s desire to diversify its portfolios will not mean continued accumulation of claims on any particular country. As long as a nation continues to develop and offers a sufficiently stable economic and political environment so that the rest of the world expects it to continue to service its debts, its assets are likely to remain in demand.
Therefore, the key is whether the private sector and external account deficits are associated with productive investments that increase the country’s ability to service the associated debt. As acknowledged even by the IMF, a country’s ability to run persistent current account deficits ultimately depends on ‘whether the borrowing will be financing investment that has a higher marginal product than the interest rate (or rate of return) the country has to pay on its foreign liabilities’.45 If this condition is met, a country can continue to run a current account deficit even in the face of a rising foreign debt-to-GDP ratio. It is thus possible for a country’s standard of living to be increased in the short term and in the long term as a result of a current account deficit. This explains why so many countries – the vast majority of the world’s countries, in fact – have been able to run persistent current account deficits for years without incurring balance-of-payments crises. Australia provides a good case in point. The country has run a current account deficit of varying sizes relative to the economy for most of the period for which data are available. As a result, its foreign debt has grown exponentially over the years (in absolute terms and as a percentage of GDP). However, as noted in a report by the Parliament of Australia, this is not a cause of concern for the country:
The size of Australia’s foreign debt would be a cause for concern if it was mainly caused by increased consumption rather than increased investment, raising concerns that Australia was living beyond its means. However, Australia’s national saving and national investment levels are both above their long-term average, suggesting Australia is well able to cover the servicing of its debt.46
This is illustrated by the fact that the country’s debt-service ratio has been steadily declining for years despite the growing level of foreign debt.47 Of course, if a country’s spending pattern yields no long-term productive gains – if, that is, the borrowed funds are used simply to fuel consumption rather than investment – then its ability to service the debt might indeed come into question. However, we need to distinguish between foreigner-held private sector debt and foreigner-held government debt. As we have seen, the national government can always service its debts so long as these are denominated in the domestic currency. In the case of national government debt, it makes no significant difference for solvency whether the debt is held domestically or by foreign holders because it is serviced in the same manner in either case – by crediting bank accounts. In the case of private sector debt, on the other hand, this must be serviced out of income, asset sales or further borrowing. This is why long-term servicing is enhanced by productive investments and by keeping the interest rate below the overall growth rate. It should be noted, however, that private sector debts are always subject to default risk – and should they be used to fund unwise investments, or if the interest rate is too high, private bankruptcies are the ‘market solution’ (though the government can always soften the impact of these on the wider economy).
It is also important to distinguish between foreign debt held in the domestic currency and debt held in a foreign currency. If the foreign debt is denominated in a foreign currency, then a depreciation of the domestic currency, falling income (for example due to falling export prices) or higher world interest rates can render the country – including the government – unable to make interest and principal repayments. However, if the external debt is denominated in the domestic currency, then the depreciation would have no effect on the value of the debt. This implies that countries with large external debts are in greater danger of default if the external debt is largely denominated in a foreign currency, and therefore that the use of foreign-denominated debt should be kept to a minimum. Not surprisingly, most balance-of-payments and currency crises in developing countries – such as Mexico in the 1980s and the East Asian countries in the 1990s – were associated with high levels of dollar-denominated debt, along with various forms of currency pegs.
It should further be noted that the world’s desire to accumulate claims against the deficit country can decline independently of the country’s underlying trade and/or economic fundamentals. That is because in today’s world the impact of the former on the exchange rate is generally overwhelmed by the impact of cross-border gross financial flows, which can behave rather irrationally. In this sense, all open economies are susceptible to balance-of-payments fluctuations. That is, while there is no such thing as a balance-of-payments growth constraint in a flexible exchange economy in the same way as it exists in a fixed exchange rate environment, the external balance still has implications for foreign reserve holdings via the level of external debt held by the public and private sectors. For this reason, nations facing continual current account deficits should also foster conditions that will reduce their dependence on imports, through well-targeted import substitution policies. However, while these fluctuations were terminal during the gold standard era for deficit countries because they meant that governments had to keep the domestic economy is a permanently depressed state to keep imports down, in a flexible exchange rate environment movements in the exchange rate respond to balance-of-payments states and are therefore able to make the adjustment much less painful. This does not mean that a flexible exchange rate delivers an automatic rebalancing of the current account, as Milton Friedman and others claimed. In fact, evidence shows that current account deficits can persist even in the face of a depreciating currency. That is because the trade balance is largely demand-driven – that is, it is based on the level of domestic and foreign demand (the residents’ and foreigners’ desire to save/dis-save) – not price-driven, and therefore the ability of a depreciation to improve a country’s balance of trade by making exports more competitive is often overstated, although it may indeed play a role in some circumstances. It does mean, however, that if, for whatever reason, the world’s desire to accumulate claims against the deficit country were to decline – which means that the nation in question would have to reduce its excess of imports over exports, which may indeed prove painful in the short term – currency depreciation (even though this usually implies a fall in real wages due to rising import costs) is a less painful option than internal devaluation (lower nominal wages and/or government spending), which is the only option available to countries operating in a fixed exchange rate regime.48
Another oft-heard claim is that currency depreciation is intrinsically inflationary: that in a system of flexible exchange rates, as the currency begins to lose value relative to all other currencies, the rising import prices (in terms of the local currency) are passed through to the domestic price level – with accelerating inflation being the result. It is thus claimed that if the government persists in pursuing domestic full employment policies in the face of a depreciating currency, domestic inflation will worsen and the country will end up with a chronically depreciated currency, resulting in a collapse of material living standards. This argument is particularly potent in the context of the eurozone, where it is often claimed that if a country were to abandon the euro it would inevitably face severe inflationary pressures due to the depreciation of the new currency against other major currencies. In fact, empirical evidence shows that ‘the correlation between changes in consumer prices and changes in the nominal exchange rate has been quite low and declining over the past two decades for a broad group of countries’.49 A recent Bank of England paper on the topic provides three broad conclusions:
First, contrary to common belief, exchange rate movements don’t seem to consistently have larger effects on prices in sectors with a higher share of imported content. Second, exchange rates don’t seem to consistently have larger effects on prices in the most tradable and internationally-competitive sectors. Third, the effects of exchange rates on inflation – and even just on import prices – do not seem to be consistent across time.50
The euro is a good case in point. Over the 2008–16 period, the euro has lost around 30 per cent of its value against the dollar. This, however, has not been accompanied by runaway inflation in Europe; on the contrary, the continent continues to be mired in ‘lowflation’ if not outright stagnation. Ultimately, it seems pretty clear that even though currency depreciation does create some exchange rate pass-through to the domestic economy, this is certainly not enough to trigger hyperinflation and certainly not enough to derail a full employment programme based on stimulating domestic demand. Moreover, as mentioned, if the debt is denominated in the local currency the depreciation would have no effect on the value of the repayments. This is consistent with our argument that a monetarily sovereign nation that floats its currency has much more domestic policy space than is considered possible by the mainstream, and can make use of this space to pursue rising living standards even if this means an expansion of the current account deficit and a depreciation of the currency. Ultimately, the best way to stabilise the exchange rate is to build sustainable growth through high employment with stable prices and appropriate productivity improvements, even if the higher growth is consistent with a lower exchange rate. A low-wage, export-led growth strategy, on the other hand, sacrifices domestic policy independence to the exchange rate – a policy stance that at best favours a small segment of the population.
Of course, in extreme cases, the world’s desire to accumulate claims against a deficit country could disappear entirely, in which case the country’s current account deficit would get forcibly squeezed down to zero. It might also happen relatively quickly. This is known as a ‘sudden stop’ and is usually associated with a sudden slowdown or reversal of short-term speculative capital flows, also known as ‘hot money’. This harks back to the distinction drawn above between capital inflows that manifest themselves as FDI in productive infrastructure – which are relatively unproblematic, since they create employment and physical augmentation of productive capacity that becomes geographically immobile – and capital inflows that are not connected to the real economy and are purely speculative in nature, which tend to fuel unsustainable consumption booms (that inevitably go bust). Most boom–bust financial crises in developing countries in recent decades were associated with capital inflows of this nature, with foreign investors rushing into a country in search of short-term profits and then rushing out when things turned sour. A flexible exchange rate per se provides no defence against these destructive flows. However, evidence shows that ‘sudden stop’ episodes are much more common in fixed exchange rate regimes.51 In fact, it is often forgotten that the Bretton Woods system was ultimately derailed precisely by speculative capital flows that threatened the exhaustion of the foreign exchange and/or gold reserves of nations running external deficits. That said, countries can – and should – defend themselves from the destructive macroeconomic impact of rapid inflows and/or withdrawals of financial capital, regardless of the currency regime. There are a number of tools that nations can employ to that end, first and foremost capital controls.
Up until the 1970s, capital controls – that is, mechanisms or instruments to limit the amount of capital that is flowing into and/or out of a country – were an integral part of the post-war Bretton Woods system, and at the time were endorsed by most mainstream economists and international institutions (including the IMF), since unfettered cross-border capital flows were considered inherently volatile and destabilising. As Carmen Reinhart and Kenneth Rogoff explain, the relative calm that characterised the period between the late 1940s and early 1970s ‘may be partly explained by booming world growth, but perhaps more so by the repression of the domestic financial markets (in varying degrees) and the heavy-handed use of capital controls that followed for many years after World War II’.52 Throughout the 1970s, though, as neoliberalism gained strength worldwide, the United States, other Western governments and the international financial institutions (such as the IMF and the World Bank) began to take an increasingly critical view of capital controls. The idea was that capital account liberalisation would allow for more efficient global allocation of capital, from capital-rich industrial countries to capital-poor developing economies. Thus, throughout the 1980s and 1990s, most of the restrictions limiting movement of capital were lifted, with Europe leading the way. As a result, financial crises started reoccurring with increased frequency, especially in the developing world. This has led the IMF to reverse its long-standing position on capital controls – somewhat. In a 2010 Staff Paper, the IMF argued that capital inflow surges compromise sound macroeconomic management, by pushing the exchange rate up and undermining trade competitiveness.53 It also acknowledged that ‘large capital inflows may lead to excessive foreign borrowing and foreign currency exposure, possibly fueling domestic credit booms (especially foreign exchange denominated lending) and asset bubbles (with significant adverse effects in the case of a sudden reversal)’.54 It concluded that ‘if the flows are likely to be transitory, then use of capital controls … is justified as part of the policy toolkit to manage inflows’.55
More recently the IMF further developed its position, claiming that FDI that ‘may include a transfer of technology or human capital’ can ‘boost long-term growth’.56 Speculative debt inflows, on the other hand, not only increase the likelihood of ‘a crash’ but also increase inequality and reduce growth, and warrant the use of direct controls on capital movements. The IMF acknowledges that capital controls are particularly useful for countries that have little room for economic manoeuvre, such as those that are part of a fixed exchange rate system, because they are less equipped to deal with economic shocks.57 However, even in a flexible exchange rate regime, capital controls can be used to isolate capital inflows that support productive investment from speculative inflows, and to avoid destabilising exchange rate swings. It is our position that financial flows that are not connected to the real economy and are unproductive in nature, along with a whole other range of financial transactions that drive cross-border capital flows, should not simply be ‘controlled’ – they should be declared illegal (the issue of financial repression is discussed in further detail in Chapter 10). This may be considered an extreme form of direct control. Ideally, this should be introduced on a multilateral basis spanning all nations rather than being imposed on a country-by-country basis. However, in the absence of such international commitments, nations should consider unilaterally imposing capital controls as beneficial bulwarks against the destructive forces of speculative financial capital. While it is usually claimed that imposing such controls would automatically cut a country off from access to international capital markets, plunging the nation into autarchy, the experience of various countries (including a number of European countries) that have reimposed capital controls in recent years disproves this claim. Indeed, the evidence shows that countries that employed constraints on surging capital inflows fared better than countries with open capital accounts in the recent global financial crisis.58
Finally, it should be noted that there are countries – such as extremely underdeveloped countries that can only access limited quantities of real resources relative to their population and are highly dependent on imports of food and other life-sustaining goods – where the well-being of their citizens cannot be solved within those nations’ own borders, especially if their export potential is limited, regardless of the measures that the country may employ to protect itself from speculative capital flows and reduce its dependence on imports. These countries may find no market for their currencies and may be forced to trade in foreign currencies. In this sense, it should be noted that not all currencies are equal. In this context, a new multilateral institution should be created to replace both the World Bank and the IMF, which is charged with the responsibility of ensuring that these highly disadvantaged nations can access essential real resources such as food and not be priced out of international markets due to exchange rate fluctuations that arise from trade deficits. This is discussed in more detail in the next section of this chapter.
MMT shows that the ultimate constraint on prosperity is the real resources that a nation can command, which includes the skills of its people and its natural resource inventory. If a country’s resource base is very limited, there is relatively little that a country can do to pull itself out of poverty, even if the government productively deploys all the resources available to the nation. However, this is not a balance-of-payments constraint in the classical sense. It is a real resource constraint arising from the unequal distribution of resources across geographic space and the somewhat arbitrary lines that have been drawn across that space to delineate sovereign states. The world must take responsibility to ensure that it alleviates any real resource constraints that operate through the balance of payments.
Imposing austerity on these countries is no solution. The evidence shows that the structural adjustment programmes (SAPs) that the IMF and World Bank typically impose on poor nations struggling with balance-of-payments problems – based upon fiscal austerity, elimination of food subsidies, increase in the price of public services, wage reductions, trade and market liberalisation, deregulation, privatisation of state-owned assets, etc. – have had a disastrous social, economic and environmental impact wherever they have been applied. Not only have they ‘reduced health, nutritional, and educational levels for tens of millions of children in Asia, Latin America, and Africa’, as a UNICEF study concludes;59 they also foisted upon these nations unsustainable levels of external debt, which were then used to justify the imposition of destructive export-led production strategies that in many cases devastated the existing subsistence systems and led to large-scale environmental ruin (for example, massive deforestation in Mali). Masqueraded as development programmes, SAPs have actually acted as giant siphons, sucking out wealth and resources from these countries and pumping it into the pockets of the rich elites and corporations in the US, Europe and elsewhere. To add insult to injury, in many instances these policies also wrecked the borrowing countries’ local productive sectors, thus creating increased import and debt dependencies.
Clearly, the IMF and the World Bank have outgrown their original purpose and have ceased to play any positive role in the management of world affairs. Rather, their interventions have undermined prosperity and impoverished millions of people across the world, and continue to do so – mostly, but not exclusively (as the IMF’s participation in Greece’s bailout programme testifies), in the developing world. In this context, we contend that a new multilateral institution (or series of institutions) should be created to replace both the World Bank and the IMF, charged with the responsibility of ensuring that these highly disadvantaged nations can access essential real resources such as food. There are two essential functions that need to be served at the multilateral level:
• Development aid – providing funds to develop public infrastructure, education, health services and governance support.
• Macroeconomic stabilisation – the provision of liquidity to prevent exchange rate crises in the face of problematic balance of payments.
While these functions seem to align with those currently provided by the World Bank and IMF, a progressive approach to these problems would not resemble the operational procedures currently in place. With regard to the provision of development aid, the starting point for a revised sustainable development strategy should be the complete cancellation of the debt hitherto incurred by (imposed upon) developing nations. In the future, as recommended by a 2000 report by the US Congress’ International Financial Institution Advisory Commission, performance-based grants – whereby funds are granted after certain outcomes are achieved, not in order to implement an agreed set of actions – should replace traditional conditionality-based loans. In a follow-up article, two of the Commission’s leading economists argued that:
Performance-based grants would cost the same as traditional loans but they would deliver more benefits to the global poor. Grants would make programs effective, monitor output, pay only for results, prevent accumulation of unpayable debt, forestall diversion of funds for unproductive ends and protect donor nation contributions from risk of loss.60
They would also prevent the build-up of unsustainable debt because ‘there can be no outlay without benefits and no continuing financial liability if projects fail’. A progressive developmental model should also reject the current export-led corporate farming models, which are implicated in environmental degradation within less developed countries. There are many dimensions to this phenomenon, including deforestation, genetic engineering, increased use of dangerous pesticides and irrigation schemes that deplete aquifers. A progressive multilateral institution would aim to reduce (and ultimately eliminate) poverty through economic development, but within an environmentally sustainable frame. It would also allow countries to restrict imports from nations that engage in poor environmental practices – an approach that the WTO has repeatedly deemed illegal. Further, developing nations should have the right to defend and sustain their local industries. The more recent trade theories show that the presence of increasing returns to scale – where output rises proportionately more than any increase in inputs, coupled with network effects, where the creation of critical mass provides significant benefits to consumers – justifies the protection of local (and particularly nascent) industries, through the imposition of selective tariffs.61 Indeed, contrary to the claim that trade liberalisation promotes growth, the evidence indicates a positive relationship between tariffs and economic growth in developing economies.62 As seen in Chapter 5, no advanced nation achieved that status by following the IMF/World Bank free-market approach; rather, it did so through widespread industrial protection and government controls and supports.
Even though the post-war period saw the introduction of a series of agreements relating to the liberalisation of international trade (such as the General Agreement on Trade and Tariffs (GATT), which paved the way to the creation of the WTO in 1995), the trade landscape continued to remain laced with state intervention and protectionist policies. In fact, there has been an almost dichotomised development process among rich and poor nations, which dates back to the colonial era. The poorer nations (typically under (neo-)colonial rule) had ‘free trade’ forced upon them with concomitantly poor outcomes, while the (neo-)colonial powers adopted heavily protectionist positions. Further, while tariffs have come down under successive GATT and WTO rounds, the global trading terrain has been anything but level. Rich nations such as the US still maintain a complex array of tariffs on goods attempting to enter their borders. Japan, for example, maintains a highly protectionist stance with respect to its primary products (particularly rice). These cases are generalised across most nations. The reality is there for all to see: economic growth has fallen on average as the neoliberal regime has been extended; where so-called ‘liberalisation’ has been most acute, this fall has been larger. A progressive developmental policy should reject this approach flat-out and recognise the right of developing countries to choose their developmental path autonomously, with due regard for each countries’ customs, traditions, standards and priorities. This, as history shows, will likely entail the use of ‘illiberal’ trade practices such as export subsidies, import controls, restrictions on capital flows, directed credit, etc.63
In this regard, a progressive trade policy would also ban the ISDS clauses embedded in the more recent wave of trade agreements. As previously noted, these create mechanisms through which international corporations can take out legal action against governments if they believe that a particular piece of legislation or regulation threatens their opportunities for profit. This undermines the capacity of states to regulate in the public interest in a number of areas, including labour market regulation (job protection, minimum wages, etc.), the cost of medical supplies, financial market oversight, environmental protection and standards relating to food quality. The underlying assumption is that the interests of international capital should take precedence over any other consideration. Furthermore, there is very little evidence that these agreements generate benefits in terms of growth, jobs and/or exports.64 A progressive agenda would ban these agreements and force corporations to act within the legal constraints of the nations they seek to operate within or sell into. More generally, the current free trade framework – which pays little or no attention to labour or environmental standards and fuels a ‘race to the bottom’ model, where workers in poor nations are paid poverty-level wages and work in appalling and dangerous conditions, while regions in developed nations are hollowed out with entrenched unemployment and increasing poverty and social alienation – needs to be rejected in favour of a fair trade framework. The WTO has consistently avoided the inclusion of strict labour standards in its agreements, as it maintains the view that low-wage countries attract capital as a result of their comparative advantage, which leads to their development. The evidence is not supportive of this belief.65 Corporations staunchly resist the introduction of global labour standards because they know that this would undermine the global labour arbitrage that is at the basis of their strategy of profit capture. Under a fair trade framework, all countries should respect the following principles:
• Good working conditions – wages, safety, hours.
• Right to association and to strike – formation of trade unions, etc.
• Consumer protection – safety, ethical standards, quality of product or service, etc.
• Environmental standards.
Under these conditions, what we would actually have is ‘fair trade’ rather than the type of trading arrangements embodied in the raft of so-called free trade agreements. To this end, the WTO should be replaced by an all-encompassing multilateral body that is charged with establishing relevant labour and environmental standards to regulate trade. While it is recognised that nations at different stages of development will have different productive methods, working standards that are acceptable across cultures can be devised. For example, in advanced countries road building is highly mechanised with high capital-to-labour ratios relative to Africa, where labour-intensive methods are better because they can produce the same standard of output with more labour. However, within these differences, some standards remain common – the right to association, the right to adequate rest and breaks, the right to holidays, the right to fair pay, the right to strike. It is beyond the scope of this book to define all the operational details, but the general principle is clear – trade should not be allowed if it violates the principles listed above. Under fair trade principles, a nation allowing capitalist firms to deny basic workers’ rights becomes a sufficient condition to block trade with that nation. In this sense, the MMT view of trade – according to which imports represent a benefit (goods and services otherwise unattainable), in a materialistic sense, while exports represent a cost (real resources used by foreigners rather than domestic citizens) – does not militate against our critique of ‘free trade’. Indeed, it strengthens it.
Even though, generally speaking, exports are a cost and imports are a benefit, the framework within which we make those assessments is multi-dimensional and extends the concept of material progress in ways that mainstream economics typically ignores. For example, a commercial transaction that is only considered in terms of the use value that consumers receive may involve massive damage to the producing community. So while an imported good or service might be seen in narrow terms to be a ‘benefit’ for the consumer, once we broaden our assessment of the costs and benefits of the overall chain of production and consumption a more nuanced view will emerge. By adopting principles that take into account the actual costs of production – including damage to the environment, destruction of local sustainable industry, damage to human dignity, etc. – the benefits of the import for a consumer will pale into insignificance relative to the costs for a producer. In these cases, import controls may be justified to limit the damage to the less developed nation, despite the material benefits to the more developed nation. A more progressive stance, however, would be to recognise that there are circumstances in which it is in the global interest to restrict the capacity of a nation to export, for example by paying a country to avoid engaging in destructive practices such as coal mining and deforestation, thus reducing the impact on that country’s exporting capacities, particularly on the communities involved. A progressive policy framework has to allow all workers access to work, and the poorest members in each nation opportunities for upward mobility, if jobs are destroyed as part of an overall strategy to redress matters of global concern (whether to advance labour, environmental or broader issues). Part of these transition arrangements might also include more generous foreign aid to ensure that trade constraints do not interrupt international efforts to relieve world poverty. In general, a single nation should not be punished for the uneven pattern of geographic resource distribution.
With regard to the question of macroeconomic stabilisation – that is, the provision of liquidity to countries struggling with balance-of-payments problems – a progressive multilateral institution would recognise that all nations should maintain sovereign currencies and float them on international markets, but at the same time acknowledge that capital flows may be problematic at certain times and that some nations require more or less permanent assistance due to their limited export capacities and domestic resource bases. The starting point would be to recognise that as long as there are real resources available for use in a nation, its government can purchase them using its currency power. That includes all idle labour. So, there is no reason to have involuntary unemployment in any nation, no matter how poor its non-labour resources are. The government in each country could easily purchase these services with the local currency without placing pressure on labour costs in the country. A new multilateral institutional structure should work within that reality rather than use unemployment as a weapon to discipline local cost structures. In the case of a nation that is highly dependent on imported food and/or energy, the role of the international agency would be to buy the local currency to ensure that the exchange rate does not price the poor out of food. The international community would agree that this support would be ongoing and unconditional so long as the link between the imported food and/or energy and the foreign exchange intervention is clear. Moreover, the current conditionality requirements – spanning fiscal outcomes, interest rates, monetary growth, etc. – need to be abandoned.
This is a simple solution that is preferable to forcing these nations to run austerity campaigns just to keep their exchange rate higher. Furthermore, new international agreements are needed to outlaw speculation by investment banks on food and other essential commodities. More generally, a new framework is needed at the international level to ban illegal speculative financial flows that have no necessary relationship with improving the operation of the real economy. However, as mentioned, in the absence of such international commitments, nations should consider unilaterally imposing capital controls. Finally, this new multilateral institution would not force nations to cut taxes for high-income earners in return for aid, which is another bias in current IMF and World Bank interventions. It would recognise that the role of taxation is to create non-inflationary space for the sovereign government to command real resources in order to fulfil its socio-economic programme. The reality is that there are many idle resources in the poorer nations – land, people and materials – that can be bought by government and mobilised to reduce poverty without causing inflation. Finally, it should be acknowledged that these nations will likely have to run continuous fiscal and current account deficits for many years to allow the non-government sector to accumulate financial assets and provide a better risk management framework. A progressive international agency would help them to do just that.