We tend to think about the economy as we do about our households or businesses. Commentators, politicians and even some economists do this, so it is not surprising that ordinary people do as well. Using this analogy it seems logical that governments must balance their budgets and avoid deficits and debt.
However, governments are nothing like households or businesses. One way to appreciate this is to imagine that a family is the economy and the parents are the government. Now imagine that the family run a self-sufficient farm in which their only employees are family members - who they are committed to providing for. Can you think of any circumstances in which it would make sense for some healthy and willing members of the family to not do any work at all on the farm ? Or for previously productive parts of the farm to be left idle and neglected when there are members of the family that want to work on it and they could produce something that would improve the family's well being? Of course not. Not using the family's full productive capacity to increase their well-being makes no sense. Yet we accept this in the case of our economy. Why? Because, unlike our family we have introduced money into the economy, and the misguided way that we operate our monetary system forces us to accept involuntary unemployment and underused capacity.
What is it about the way we use money that does this, and can we change it? The key problem is that we treat money as a commodity and artificially restrict its supply to maintain its value (which is the same as preventing inflation). Until 1971 this restriction was imposed by fixing the amount of money to a precious commodity which was limited, such as gold. When the gold standard was abandoned because of the damaging effects it had on economic growth and global trade most countries adopted fiat currencies with floating exchange rates. This made it possible to deal with money in a way that allowed full employment and use of all productive capacity. Unfortunately this opportunity has not yet been taken up. It has been prevented by a set of self-imposed restraints that have been adopted by almost all countries. These restraints mean that we think and act as though we are still on the gold standard with fixed exchange rates.
SPENDING CREATES MONEY, TAX ELIMINATES IT
To explain how a fiat currency system works lets return to the analogy of the family. Assume that parents decide to introduce money into the family economy which they issue as coupons. To get the coupons accepted they require their children to pay a monthly charge or tax payable only with those coupons. Because they need to pay the tax the children will work to earn coupons. Since the parents make the coupons at no cost they can employ all the children. And if they were being rational they would, since this would increase the total output of the family. It is important to appreciate that taxes are not needed to collect coupons to pay the children. Parents can create coupons at will so can pay their children even if they collect no coupons through taxes.
TAXES CREATE DEMAND FOR THE CURRENCY AND HELP CONTROL INFLATION
So why have taxes? For two reasons. Firstly because they create demand for the coupons or currency and give them value. Since taxes are compulsory and the family can enforce payment this creates a demand for the currency. Fiat currencies are backed by the state. Since the coupons have value they will be used for trade between the children. They could even employ each other. This trade will result in prices being set.
If the number of coupons increases more rapidly than the available items to be traded prices will increase - inflation. Prevention of inflation is the second reason for taxation. By removing coupons that parents have spent into the economy they restrict demand and reduce inflationary pressures.
GROWTH REQUIRES DEFICITS
Now imagine that the number of children and grandchildren increase over time and because of innovation they become more productive as well. This necessitates and increase in the number of coupons in line with an increase in the amount of economic activity. One way to do this is for parents to always spend more coupons than they remove through taxation. In other words to run a 'budget deficit'.
SAVING REQUIRES DEFICITS
Imagine that the family economy did not grow at all in terms of number or productivity. However some children decided to save some of their coupons by hoarding them under their bed. This saving is clearly only possible if the parents take back fewer coupons by taxing than they issue by spending. Thus the children, analogous to the 'non-government' sector, can only save if the parents, analogous to the 'government' sector run a budget deficit. And their net savings must equal exactly the parental 'deficit'.
'GOVERNMENT DEBT'
Now imagine that the parents decided that they would offer to look after the coupons that children had previously saved under their beds and pay interest on them as well. Since these extra 'saved' coupons arise from the 'deficit' these coupons stored by the parents are formally equivalent to the government 'debt'. Clearly it is absurd to think of this 'debt', which is just the accumulated savings of the children, as a burden on the children. It is also ridiculous to think that parents could default on this 'debt'. How could they when they can make and issue coupons at no cost? This parental (or government) 'debt' is really just a very safe savings account for the children (or non-government sector).
In this post I have tried to create an accurate analogy between economies and families to explain the role of government spending, taxation and debt in economy. The key concept is the notion that government are the sole suppliers of money and can never run out of it. It makes sense for them to use it to maximise employment and productive output, and they can do this by adjusting the deficit. Increasing it when there is unemployment and recession and decreasing it when there is inflation.
In the next post I will introduce bank lending into the analogy as this is needed to explain the origins of the current financial crisis.
However, governments are nothing like households or businesses. One way to appreciate this is to imagine that a family is the economy and the parents are the government. Now imagine that the family run a self-sufficient farm in which their only employees are family members - who they are committed to providing for. Can you think of any circumstances in which it would make sense for some healthy and willing members of the family to not do any work at all on the farm ? Or for previously productive parts of the farm to be left idle and neglected when there are members of the family that want to work on it and they could produce something that would improve the family's well being? Of course not. Not using the family's full productive capacity to increase their well-being makes no sense. Yet we accept this in the case of our economy. Why? Because, unlike our family we have introduced money into the economy, and the misguided way that we operate our monetary system forces us to accept involuntary unemployment and underused capacity.
What is it about the way we use money that does this, and can we change it? The key problem is that we treat money as a commodity and artificially restrict its supply to maintain its value (which is the same as preventing inflation). Until 1971 this restriction was imposed by fixing the amount of money to a precious commodity which was limited, such as gold. When the gold standard was abandoned because of the damaging effects it had on economic growth and global trade most countries adopted fiat currencies with floating exchange rates. This made it possible to deal with money in a way that allowed full employment and use of all productive capacity. Unfortunately this opportunity has not yet been taken up. It has been prevented by a set of self-imposed restraints that have been adopted by almost all countries. These restraints mean that we think and act as though we are still on the gold standard with fixed exchange rates.
SPENDING CREATES MONEY, TAX ELIMINATES IT
To explain how a fiat currency system works lets return to the analogy of the family. Assume that parents decide to introduce money into the family economy which they issue as coupons. To get the coupons accepted they require their children to pay a monthly charge or tax payable only with those coupons. Because they need to pay the tax the children will work to earn coupons. Since the parents make the coupons at no cost they can employ all the children. And if they were being rational they would, since this would increase the total output of the family. It is important to appreciate that taxes are not needed to collect coupons to pay the children. Parents can create coupons at will so can pay their children even if they collect no coupons through taxes.
TAXES CREATE DEMAND FOR THE CURRENCY AND HELP CONTROL INFLATION
So why have taxes? For two reasons. Firstly because they create demand for the coupons or currency and give them value. Since taxes are compulsory and the family can enforce payment this creates a demand for the currency. Fiat currencies are backed by the state. Since the coupons have value they will be used for trade between the children. They could even employ each other. This trade will result in prices being set.
If the number of coupons increases more rapidly than the available items to be traded prices will increase - inflation. Prevention of inflation is the second reason for taxation. By removing coupons that parents have spent into the economy they restrict demand and reduce inflationary pressures.
GROWTH REQUIRES DEFICITS
Now imagine that the number of children and grandchildren increase over time and because of innovation they become more productive as well. This necessitates and increase in the number of coupons in line with an increase in the amount of economic activity. One way to do this is for parents to always spend more coupons than they remove through taxation. In other words to run a 'budget deficit'.
SAVING REQUIRES DEFICITS
Imagine that the family economy did not grow at all in terms of number or productivity. However some children decided to save some of their coupons by hoarding them under their bed. This saving is clearly only possible if the parents take back fewer coupons by taxing than they issue by spending. Thus the children, analogous to the 'non-government' sector, can only save if the parents, analogous to the 'government' sector run a budget deficit. And their net savings must equal exactly the parental 'deficit'.
'GOVERNMENT DEBT'
Now imagine that the parents decided that they would offer to look after the coupons that children had previously saved under their beds and pay interest on them as well. Since these extra 'saved' coupons arise from the 'deficit' these coupons stored by the parents are formally equivalent to the government 'debt'. Clearly it is absurd to think of this 'debt', which is just the accumulated savings of the children, as a burden on the children. It is also ridiculous to think that parents could default on this 'debt'. How could they when they can make and issue coupons at no cost? This parental (or government) 'debt' is really just a very safe savings account for the children (or non-government sector).
In this post I have tried to create an accurate analogy between economies and families to explain the role of government spending, taxation and debt in economy. The key concept is the notion that government are the sole suppliers of money and can never run out of it. It makes sense for them to use it to maximise employment and productive output, and they can do this by adjusting the deficit. Increasing it when there is unemployment and recession and decreasing it when there is inflation.
In the next post I will introduce bank lending into the analogy as this is needed to explain the origins of the current financial crisis.
This was veryinteresting. Another analogy I have been thinking about for a while (though still working on articulating) is of the government to the "bank" in monopoly. The one query I have is to do with private credit creation in banks, so one child being able to lend out credit (and thus effectively print coupons), but I assume you'll deal with that in the next post. Thanks!
ReplyDeleteYes that was the plan. Introduce moneylenders, then banks, the central bank and the payment system.
ReplyDelete