A spectre is haunting treasurers across the globe—the spectre of COVID debt. Newspaper headlines blare about the ‘unsustainable burden’ public debt is placing on future generations. While governments on the left and the right have temporarily suspended the usual fretting about deficits, the old debt bogeyman is alive and well. The ‘snapback’ some have spoken of applies as much to the political class’s deficit phobia as it does to the Australian economy, and once the crisis passes, politicians’ brief flirtation with classical Keynesianism will likely end and the old rhetoric about the need to balance the budget will make a comeback.
This time, however, we can choose as a society not to return to inaccurate, outdated ideas and instead build national economic policy on a factually correct basis.
There is a growing recognition across the globe that the story about federal budgets most of us have learned—including in most macro-economic textbooks—is not entirely accurate. New ideas, sometimes called ‘heterodox economics’ (as opposed to orthodox or mainstream economics), Post-Keynesian economics or modern monetary theory (MMT), are rapidly gaining traction, not because they tell us what we want to hear, but precisely because they don’t. The new paradigm is emerging because the evidence of the last twelve years has challenged every preconceived political ideology and macro-economic theory we had regarding fiscal and monetary policy. Events have changed faster than our thinking, and the failure of old assumptions is forcing us to compare established ideas against new emerging theories.
Economist Steven Hail sums up the new fiscal thinking:
1. All governments are constrained by limited real resources (the availability of workers, capital equipment and natural resources), the economy’s productive capacity, and inflation.
2. Governments that issue and borrow in their own currency cannot go bankrupt.
3. The government’s surplus is everyone else’s deficit.1
This chapter aims to explain core facts about federal debt and deficits that a growing number of mainstream economists have begun to accept.
Understanding the federal budget: Some facts on how governments spend
It’s important to start with some widely misunderstood facts about how federal governments—particularly governments that issue their own currencies—spend. When it comes to budgets, governments come in two varieties: currency issuers (like the Australian, American, British, New Zealand, Canadian and Japanese governments) and currency users (state governments; local councils; national governments that use a foreign currency, such as New Caledonia; and national governments that have joined an international currency union, such as Greece in the European Union). Families, individuals, businesses, charities and unions are also all currency users: you and I can’t create Australian currency out of thin air—it’s literally a crime, known as counterfeiting. The Australian federal budget is not like a household’s, or a business’s, or a state or local government’s, or Greece’s. The Australian Government is a currency issuer, and the fact that most people confuse this with the budget of a currency user has lain at the heart of many of our problems, policy mistakes and forecasting errors for more than a decade.
The example of the government’s COVID-19 stimulus is the same as any federal budget. The government writes up an appropriations bill, passes it through parliament, and seeks the signature of the governor-general. The signed bill is then sent to the Treasury, which puts together corresponding money orders that are then sent on to the Reserve Bank of Australia (RBA). The RBA facilitates the necessary payment or payments by marking up certain accounts, called ‘reserve accounts’, held at the central bank. Just as you and I have our own accounts with particular banks, so banks and other authorised deposit-taking institutions have their own accounts at the RBA, ‘the banks’ bank’. When the RBA is handed a spending decision from the federal government, it ‘clears the cheque’ by marking up the reserve account of the intended recipient’s bank (after all, you or I or any other non-financial institution can’t take out an account at the RBA, so the RBA can’t deposit money directly into our savings account). This money—which pays for all federal spending activities—does not ‘come’ from anywhere other than a computer keyboard at the RBA.
Federal government spending is always paid for by new money at the central bank. In that sense, the debate about ‘printing money’ or ‘monetising deficits’ is a defunct argument. The (currency-issuing) government spends by marking up reserve accounts. Likewise, when it taxes, it simply marks down reserve accounts.
This may sound controversial, but a growing number of prominent economists have begun to admit that it is simply a correct description of the federal spending process. They include one of the world’s most cited economists, former IMF Chief Economist Olivier Blanchard, who said of new fiscal thinking:
One of its propositions is that, in contrast to standard mainstream arguments, government spending is automatically financed by money creation. This typically comes with statements that one must carefully look at the flows, but that once one has looked, the proposition is obvious. I believe the proposition is both right, and utterly irrelevant. It is right: When the government buys something or pays somebody, it draws on its Treasury account at the Fed (so long as there are funds on the account, as the account cannot go negative). This indeed automatically increases central bank money in circulation. So, in this sense, the spending is automatically financed by money.2
Former UK central bank chief Mervyn King put it more bluntly in late April 2020:
printing money and allowing government to spend is essentially what goes on now. Central banks print money today and governments decide how much money to spend, that’s what we do now, there’s nothing new about it.3
Mr King, of course, is being overly crude: central banks rarely use a physical printing press, so even the term ‘printing money’ is archaic. Governments spend by having the central bank electronically mark up the relevant reserve accounts. No physical printing press is involved. As then-chairman of the US Federal Reserve Ben Bernanke said in 2009 about the Wall Street bailouts, ‘it’s not taxpayers’ money … these banks have accounts with the Fed … we use a computer to mark up the size of the account’.4 RBA governor Phil Lowe made similar statements regarding the Australian central bank’s bond-buying program in response to COVID-19 in May 2020.5
Former chief economist of the US Senate Budget Committee Professor Stephanie Kelton, whose New York Times bestseller The Deficit Myth became an overnight sensation in mid-2020, frames the distinction between the new understanding and the old using acronyms: STAB, or ‘spend, then tax-and-borrow’, versus TABS, or ‘tax-and-borrow, then spend’. As she writes, most of us have grown up with the TABS model in our heads. It works for us because it’s relatable to our own personal experience: as currency users rather than issuers, you and I have to earn dollars from an external source before we can spend. But as the title of a 1998 paper by Kelton suggests, currency issuers not only don’t have to spend this way but, technically speaking, they can’t. In ‘Can taxes and bonds finance government spending?’, Kelton found that after a detailed analysis of central bank reserve accounting operations, ‘the proceeds from taxation and bond sales are technically incapable of financing government spending and modern governments actually finance all of their spending through the direct creation of high-powered money’.6
American bond trader and economist Warren Mosler likens it to a movie theatre: the cinema has to issue tickets to users at the box office first before it can re-collect those tickets at the admissions desk. It logically can’t work the other way around. The Australian Government, as the monopoly issuer of the Australian dollar, must issue dollars through spending first before it can re-collect those dollars in taxes.
Note the critical distinction. Kelton and her colleagues—and even some of their mainstream critics, like Blanchard and King—are not saying the government should just ‘start printing money’. They are saying something else: the government already pays for all its spending, all the time, by creating new money at the central bank. This may be a factually and technically correct description of how federal budgets work, but how politicians and taxpaying voters respond to this fact is an entirely different question, and one that economists cannot answer on their own. I will canvas some of those implications later, but for now, it is fair to say that the response from many old-school economists—of simply ignoring or denying this fact in the hope that it will simply go away—will not do.
The crucial implication is that currency-issuing governments cannot go bankrupt. This point is pushed not only by MMT economists like Kelton, Bill Mitchell and Hail, but also by others, like former US Federal Reserve chair Alan Greenspan and Goldman Sachs chief economist Jan Hatzius. But as Kelton notes, this is not a free lunch, nor is it a green light for governments to just spend, spend, spend. Fiscal responsibility matters, and deficits matter—but they matter because of inflation, not bankruptcy. The federal government can’t go bankrupt, but it can still overspend and cause inflation.
It’s worth tackling the most obvious question, then: Doesn’t ‘printing’ (creating) money cause inflation?
Inflation: Why your high school history teacher got Weimar Germany and the ‘printing money’ story wrong
The late right-wing economist Milton Friedman’s famous statement that ‘inflation is always and everywhere a monetary phenomenon’ still haunts the thinking of most orthodox economists. The thinking goes that if governments and central banks increase the supply of money, money becomes less valuable. It’s the kind of thinking that seems intuitive. However, the events of the last twelve years suggest Friedman was wrong.
Since the global financial crisis, central banks around the world have created vast sums of money (reserves) to buy up government debt (bonds) in a process called ‘quantitative easing’ (QE). It’s been tried three times in the United States, multiple times in the United Kingdom and in the eurozone (by the European Central Bank), and multiple times in Japan since 2001. Within the establishment, economists were split on whether QE would work: the so-called ‘New Keynesians’—who support limited fiscal stimulus in extreme circumstances, but share Friedman’s belief in a ‘natural rate of unemployment’, the need to balance budgets over the cycle, and the central role of monetary policy in running the economy—believed QE would raise growth, while the ‘New Classicists’ (hardline Friedmanites) believed it would trigger dramatic inflation.
Neither camp was right. QE sank like a stone despite a massive increase in the base money supply. The result blindsided most economists. If the so-called ‘quantity theory of money’ taught in orthodox textbooks was correct, it should be impossible for money creation on such a large scale to fail to produce even a breath of inflation. Of course, the massive bond-buying exercise did push up asset prices, but not the prices of goods and services in the real economy. There has to be a better explanation for inflation.
Inflation and the real limits of government spending
The view held by classical Keynesians, Post-Keynesians, modern monetary theorists and most central banks is that inflation is a result of spending (demand) outstripping supply. QE failed to cause inflation because, as economists Randall Wray and Scott Fullwiler correctly predicted in 2010, it failed to increase spending by consumers.7 The creation of money is not, in fact, inherently inflationary. It is the spending of money that is inflationary.
Kelton talks about how every economy has its own internal ‘speed limit’: the maximum amount of ‘stuff’ it can produce in a given period. If total spending (aggregate demand) by the government, the private sector and households is greater than the economy’s productive capacity (aggregate supply), inflation will result. This can be the consequence of a surge in total spending (demand-pull inflation) or a collapse in supply (cost-push inflation). The oil crises of the 1970s and the spike in banana prices after the 2010-11 Queensland floods are examples of the latter. Zimbabwe’s hyperinflation in the 1980s was an example of both: then-President Mugabe spent colossal sums of money (enabled by the printing press) but at the same time, under his disastrous land reforms, he handed control of Zimbabwe’s most productive sector, agriculture, to military cronies who had no idea how to run a modern agribusiness. Output of the country’s most important sector collapsed.
The lessons for policy-makers are clear. Fiscal responsibility matters. Deficits matter. But the limit of deficits is the availability of scarce real resources, including the consumption of households and the private sector—not a shortage of dollars. As former productivity chair and Keating adviser Gary Banks said in 2017, ‘governments cannot redistribute what the economy cannot produce’.8 At a more basic level, none of us can buy—and the government cannot spend—what the economy cannot produce.
The NAIRU
Old-school economists, including so-called ‘New Keynesians’, have accepted that a level of involuntary unemployment is both unavoidable and desirable to contain inflation. Friedman’s ‘natural unemployment rate’ hypothesis is now known as the NAIRU, or non-accelerating inflation rate of unemployment. The central bank adjusts interest rates to raise or slow growth in order to deliberately create and maintain a level of unemployment considered commensurate with stable inflation within a target band of 2 to 3 per cent.
New-school economists increasingly reject this approach as both deeply immoral and economically wasteful. Without delving into theory, the immorality of the NAIRU is clear: we deliberately make a portion of society unemployed by keeping the number of available jobs lower than the number of people looking for work, and then we shame the unemployed for their misfortune. It is nothing short of economic gaslighting. Alternatives to the NAIRU include the job guarantee, which is a subject for another book (Pavlina Tcherneva’s The Case for a Job Guarantee is highly recommended).
Sectoral balances: The government’s surplus is your deficit
Australian federal governments have run deficits for most of our history. Bob Menzies took Ben Chifley’s surplus and turned it into a deficit, and rightly so. Australia’s postwar ‘golden age’ from 1945 to 1975 was dominated by deficits and low unemployment—an average of 2 per cent—under, for the vast majority of that time, a conservative government.
The widespread conflation of the government’s debt and deficits with ‘national’ debt and deficits is incorrect. The government is just one sector of the Australian economy. Recall that a government surplus means the government is taxing and removing more out of the economy than it is creating and spending into the economy.
If we split the economy into two sectors, the government and everyone else, a simple accounting reality emerges: both cannot be in surplus at the same time. The government’s surplus equals the non-government deficit, and vice versa. Split the non-government sector into two further sectors—the rest of the world, or foreign sector; and the Australian private sector, including households, businesses, and everyone else who isn’t either the government or the foreign sector—and another uncomfortable reality emerges: unless the foreign sector is in deficit and Australia is selling and lending more abroad than we are buying and borrowing from the rest of the world (sometimes known as a current account surplus and current account deficit), it is literally impossible for both the government and the private sector (including households) to be in surplus at the same time.
The government tightening its belt in the pursuit of a budget surplus puts pressure on private (and household) balance sheets. In the years since the GFC, this has driven Australia into record household debt, sapping wage growth and investment, and creating mounting financial instability in the economy.
The need for fiscal responsibility: Managing inflation, reining in politicians
What does all this mean for fiscal responsibility post-COVID? It means we must adopt what British economist Abba Lerner called ‘functional finance’, and abandon old-fashioned so-called ‘sound finance’.9 The government is not a household or a profit-seeking corporation, and its ‘profit’ (surplus) comes at our expense. Running surpluses for their own sake pushes the rest of us into deficit and debt. But governments can’t be allowed to overspend, either—evidence of which shows up in inflation risk, not federal bankruptcy.
The major reform priority for federal budgets should be to ‘put the budget on autopilot’ as much as possible, as Kelton put it in a public lecture in 2018. This entails introducing reforms such as the job guarantee, and bolstering other automatic fiscal stabilisers that involve the budget expanding and contracting automatically in response to changes in the business cycle, rather than leaving politicians to do all the heavy lifting of fine-tuning and micromanaging fiscal policy in real time.
Treasurers of the world unite. You have nothing to lose but your chains.
Lachlan McCall is an economist at the Department of Foreign Affairs and Trade. The views represented here are in his capacity as a graduate student at the Australian National University’s Crawford School of Public Policy and are not necessarily those of the Australian Government.