The benefits of political deadlock in the USA

We are now hearing the usual moaning in anticipation of the inevitable failure of US political leaders to agree on a budget. Yes it is sad that America is so ideologically divided that decisions are difficult to make. But it is a blessing that this deadlock, in which Republicans refuse to countenance tax increases, and Democrats will not accept spending cuts, has produced an outcome - a large budget deficit - that is exactly what is needed. It is this budget deficit that is responsible for the nascent recovery in the USA. The UK and the Eurozone are following orthodox policy by cutting government deficits, and they are floundering.

The 'consensus' view that the government deficits and debt are 'a bad thing' and must be reduced is based on largely discredited orthodox economic thinking. I find it remarkable that, although this same thinking failed to anticipate the global financial crisis, cannot agree on why it happened, and has no plausible solution (other than more of the same), anyone bothers too listen to it. 

There is an alternate view that is rapidly gaining traction, which is based on sound logic, a working understanding of modern financial systems, and abundant empirical evidence. It goes by the name of modern monetary theory (MMT).

By recognising that money-issuing governments can never be forced to default on debts in their own currency, and that budget deficits are a necessary means of injecting real financial assets into an economy (less obvious but indisputably true), in much the same way that monetizing gold did in the past, MMT shows that large deficits are essential at times when demand is so weak. Deficits inject demand so that the productive capacity of the economy can be used; everyone can then get back to work and the private sector can pay off its debts, reducing leverage from unsustainably high levels that the neoliberal consensus delivered.

Trying to cut the deficit at times like this is frankly insane. History will judge deficit hawks very harshly.

Is Germany partly to blame for the Euro crisis?

This is a very interesting academic paper which suggests that Germany efficiency in driving down wages may be responsible for the Euro crisis. What this did was increase German competitiveness, enabling Germany to be a net exporter, i.e. run a (very) large current account surplus.

Having such a large net exporter within the Eurozone creates havoc because it requires other countries to be net importers, i.e. run current-account deficits. Now, it is a simple accounting fact that countries that run current account deficits must have public sector and/or private sector deficits. In other words either public sector and/or private borrowing must increase. In Greece and Italy it was primarily public sector borrowing. In Spain and Ireland it was private sector borrowing.

The point to understand is that this is a zero-sum game. Germany can only be a net exporter within the Eurozone if other countries are net importers. Germans can only be frugal if other countries are not frugal.

Another way of looking at it is to say the Germans could only keep their public sector and private sector borrowing as low as it has been by running a large current account surplus and forcing other countries to do the opposite.

This is like old-fashioned mercantilism under the gold standard, where countries try to be net exporters in order to get their hands on the limited supply of gold and accumulate large gold reserves. One could bankrupt other countries through exports.

Mercantilism was one of the reasons why the gold standard was eventually abandoned and replaced by fiat currencies and floating exchange rates.

This meant that mercantilism was no longer possible. With floating exchange rates if countries were net exporters their currencies would appreciate in values which would, by increasing the cost of their exports and decreasing the cost of their imports, function to reverse or rebalance this trade imbalance.

However the introduction of the Euro re-introduced the zero-sum game of mercantilism within the Eurozone. Germany could aggressively export and essentially suck Euro's out of the rest of the Eurozone, forcing these countries to go into public and private debt.

Clearly this is not sustainable, and so the Eurocrisis was inevitable. If Greece had not been in the Eurozone other countries would be affected. If Greece leaves the Eurozone, other countries will be in the firing line as long as Germany is allowed to run such a large current account surplus.

Either Germany must rebalance its economy or it should leave the Eurozone.

The EU now recognises that these trade imbalances are harmful and introduced (potentially punitive) measures to correct them through its Macroeconomic Imbalance Procedure. It is interesting that the threshold for the current account deficit is set at -4% whereas the threshold for current account surplus is set at +6%. If you think about this for a moment you will appreciate that it is outrageously unfair. It is MUCH easier and less painful to reduce a surplus than it is to reduce a deficit. All you do is encourage your population to buy more nice imported stuff by paying them higher wages or reducing taxes. And yet surpluses are given a higher threshold, meaning that most of the adjustment will need to be done by the deficit countries. So why this irrational difference? Here is a clue: Germany's surplus is 5.9%, so setting the threshold at 6 percent means Germany needs to make no adjustment, event though it would be almost painless. Instead everyone else has to subject their people to painful changes, which will be made much harder by the fact that Germany is not having to adjust. A more logical and fairer system would make the surplus threshold lower than the deficit threshold so that most of the adjustment is done by surplus countries.

Ideology and ignorance

Read this blog entry by Professor Bill Mitchell to see why he concludes that:

"The fact that the business groups often lead the charge against budget deficits reflects the triumph of ideology over good judgement and the triumph of ignorance over understanding."

Change of name

You may have noticed a change in the name of my blog. It was (gently) pointed out to me that the previous name could give the impression I was some sort of neofascist nutcase.

More on the damage that fiscal surpluses do

Government deficit spending is when the government introduces more money into the economy through spending than it removes through taxation. This enables the private sector to increase its savings by exactly the same amount.

Conversely budget surpluses remove financial assets from the economy, forcing the private sector to decrease savings and/or increase debt.

It should come as no surprise then that sustained periods of government surpluses can precipitate financial crises. As noted in a previous post, all six depressions in US history were immediately preceded by several years of budget surpluses. In addition, the financial crash in Japan in 1990 was preceded by budget surpluses. Finally, the Asian financial crisis of 1997 was preceded by US budget surpluses, which created a global shortage of dollars.

Why the Eurozone is fundamentally flawed

It is a fundamental requirement of any growing economy that the amount of money available increases at approximately the same rate as its potential output.

The money supply can grow either by creation of money ('printing money') or by private loan creation. However loan creation is always associated with a matching debt. So it does not increase the net financial assets in the economy.

Before the gold standard was abandoned in 1971 money was created when gold was acquired. This was called monetizing gold. However the supply of gold was limited, which meant that the amount of money became a constraint as growth accelerated. The solution was first to devalue currencies and then abandoned the gold standard.

Once the gold standard was abandoned it became possible for currency-issuing governments to create money as their economies grew. They do this by creating money, spending it, and then taking only some of it back in the form of taxes.  This is deficit spending. If they balance their budget they do not create net new money. If they run a budget surplus they actually destroy money.

When the Eurozone system was set up all governments within it lost the power to create money. Furthermore the European Central Bank is expressly forbidden from funding governments. The authority to create money was completely separated from any government. This is unprecedented, a bold experiment.

Crucially, this new arrangement meant that there was no mechanism to create money in the Eurozone. Constraints on money creation were are even tighter than they were with the gold standard.


Think about this for a moment. There is no way of increasing the net financial assets within the Eurozone. Whatever they were at day zero they would remain at that level forever more.

Does anyone else see the problem here!?

Consequently Eurozone growth is entirely dependent growth in private debt. Since no increase in net financial assets is possible, the level of leverage has to increase, relentlessly.

That seems like a recipe for disaster. And, lo and behold, disaster has struck.

Because much of this borrowing was concentrated in peripheral Eurozone countries they have been blamed for the crisis. But it really was the inevitable consequence of a fundamentally flawed monetary system.

Why public sector deficits are prudent and surpluses are reckless

Those of us who approve of prudent financial behaviour are naturally inclined to think that it is prudent for governments to reduce their budget deficit and even run surpluses to pay of the 'national debt'.

However this is wrong, tragically wrong.

It is wrong because it misunderstands the crucial difference between the currency-issuing authority, that is the government, and everyone else who are currency users. [Note that Eurozone governments are currency users and this post does not apply to them]

Currency-issuers have a very different role from currency-users because they control, through spending and taxation, the amount of private saving that is possible in an economy. By extracting less in taxes than they spend into the economy (i.e. by running a deficit) a currency-issuing government allows the collective private sector to behave in a prudent manner and accumulate savings. Conversely, when such a government extracts all that it spends (i.e. balances its budget), or extracts MORE than it spends (run a budget surplus), it forces the collective private sector to borrow, and this can result in dangerous increases in private debt, insolvency and economic collapse. It is an under-appreciated fact that all of the 6 depressions in the past 220 years of American history were immediately preceded by several years of budget surpluses, as 'prudent' Governments tried to pay down the national debt. Conversely, multi-year budget surpluses have always been immediately followed by depressions.

The point is that when currency-issuing governments behave 'prudently' and pay off their 'debt' the collective private sector is forced to increase its aggregate debt, and this may be highly imprudent. Requiring a currency-issuing government to balance it budget means that the central bank issues no new currency to support demand and growth. Instead it can only encourage private borrowing. For the economy to grow this borrowing must increase relentlessly, until it eventually becomes unsustainable, as happened in 2007/8.

Only once we understand the essentially different role of currency-issuing authorities (which need to expand the money supply in line with real economic output) and currency-USING authorities, which must only spend what they can earn, will we be able to combine economic growth with sustainable levels of private sector debt.

Reductio ad absurdum

I was mystified by a recent blog by one of our most highly respected economics commentators. This is a good example of how the incorrect assumption that government deficits are bad and must be eliminated causes even smart economists like Martin Wolf to reach absurd conclusions. He understands sectoral balances and so appreciates that the government budget deficit must equal net private savings. But then he assumes that reducing the government deficit must take priority and so policies need to be introduced to reduce private savings! Surely if there is one thing we can all agree on it is that private debt was too high and needs to be reduced to more sustainable levels. This was the root cause of the financial crisis, for heavens sake! So net private saving is a GOOD thing and exactly what is needed to get to more sustainable levels of leverage. The problem he has is that accepting this means accepting that the government budget deficit must be a good thing as well, and we know that can't be the case, don't we! This a beautiful example of the failure of orthodox economic thinking.

Perpetuating a myth....

I see the current Oxford undergraduates are being misled in their macroeconomic lectures - the slide below is from a recent lecture.

The notion that a budget deficit reduces savings is wrong. In fact it is exactly the opposite. It is necessary for the government to have a deficit in order to allow the private sector to save. This is because the public sector deficit must equal private sector savings. This is an accounting identity.

It is also intuitively obvious that the private sector can only save (spend less that it earns) if the public sector takes back in taxes less than it spends. Where else is the money going to come from?

This is the 3rd of the Seven Deadly Innocent Frauds Of Economic Policy described by Warren Mosler, one of the fathers of Modern Monetary Theory.

When our elite students are being taught this it is no surprise that everyone is so confused!

Modern monetary theory: an introduction

I have written an introductory article on Modern Monetary Theory.

First post

I have started this blog to spare family, friends and colleagues from being bombarded with emailed commentaries on Modern Monetary Theory (MMT), a recent enthusiasm of mine. Some have protested that they are not interested. Fair enough. Others find that my comments are difficult to follow. This blog will allow me to provide sufficient detail for the latter without annoying the former.