Orthodox theory makes a fine distinction between fiscal
and monetary policy. Monetary policy has to do with controlling the private
creation of money (mostly, bank deposit expansion) through control over the
quantity of bank reserves emitted. Reserves are increased either through open
market purchases by the central bank, or through loans at the discount window.
The central bank can choose either a money target or an interest rate target; in
the simplest models (without stochastic variables), this reduces to much the
same thing. Fiscal policy has to do with government spending and taxing, and if
tax revenues prove insufficient, then with “financing” government spending
through borrowing. Both theory and policy reject with horror the possibility
that fiscal and monetary operations might be combined, for example, through
government “finance” of its spending by “printing money”. For this reason, to a
greater or lesser degree, central bank “independence” is maintained to prevent
the hyperinflation that would surely result from confusion of fiscal and
monetary policy operations.
I will argue that this orthodox
view is useless for analyzing the operations of a nation operating with what I
will term a “sovereign currency”. Before going further it is necessary to define
this term as I use it. By “sovereign currency” I mean a “nonconvertible”,
floating, currency that is accepted by the government issuer in payment of taxes
and other liabilities due to the government. Let me be clear on what I mean by
nonconvertible: I mean that the government does not promise to convert its
currency to gold (or other precious metal) or to foreign currency at a fixed
exchange rate. Of course there can be exchange markets in which the currency is
bought and sold, and the government might even dabble in those markets to try to
affect the exchange rate. Finally, the government issuer must be able to impose
tax liabilities on the population (in a democracy, this is supposed to be a
self-imposition, but the key is that tax payment is not voluntary at the
individual level) that are denominated in the same currency. Hence, the dollar
in the US, or the yen in Japan are examples of what I mean by sovereign
currencies. When Argentina operated with a currency board, it did not have a
sovereign currency. Today it does. Orthodox theory may well have been useful for
analyzing Argentina before it abandoned the currency board, but it is no longer
useful.
Unfortunately, economists and
politicians are so accustomed to thinking of the operation of non-sovereign
currencies (say, the gold standard) that they have great difficulty in
understanding the economic possibilities of nations that operate with sovereign
currencies. Countries with non-sovereign currencies probably cannot (as a
general rule) “afford” full employment programs. However, any country with a
sovereign currency can “afford” full employment programs—such as Argentina’s
heads of household program, which is a limited “employer of last resort” (ELR)
type program. It is in this sense that I argue that a sovereign currency is a
pre-requisite to ELR. I do not wish to debate here the question whether a
country with a non-sovereign currency might be able to achieve full employment
without an ELR type program, but I think the real world evidence is strong
against that. What I do want to argue, however, is that any country with a
sovereign currency can afford an ELR program with which it will
achieve full employment.
Let me first briefly describe
operation of fiscal policy in a nation with a sovereign currency. I will then
turn to a brief analysis of monetary policy in such a nation. I will conclude
with some balance sheets to demonstrate the main points made. For shorthand, let
me refer to a nation with a sovereign currency as a “sovereign nation”. I
realize that traditional definitions of “sovereignty” would include additional
powers and concepts, but clearly the ability to impose taxes, to issue a
currency, and to name what will be accepted in payment of taxes are all critical
sovereign powers.
In a sovereign nation, the
government imposes a tax, with that liability denominated in the government’s
currency—say, the dollar. The citizens must obtain at least that many dollars so
that they can meet their tax liabilities. The government also names exactly what
it will accept in payment of taxes. For simplicity of analysis, we can examine
the case in which government issues a currency in the form of paper dollars and
accepts only those paper dollars in tax payment. Because the government is the
monopoly issuer of the paper dollars, and because taxpayers must obtain them,
the government can set the terms on which it will provide the paper dollars. Of
course, in a market economy, government would use the paper dollars to buy on
the market the combination of goods and services it wishes; sellers of goods and
services to government can then use the paper dollars to pay taxes. When the
paper dollars return to government, it either burns them or stores them for
re-use, whatever is more efficient. However, today in all sovereign nations,
governments actually use banks to intermediate payments. Governments accept
checks written by taxpayers on their bank accounts, then debit bank accounts at
the central bank, which operates as an agent of the government (more below on
this). Governments buy goods and services by issuing a check on the treasury,
or, increasingly, by crediting the seller’s bank account. In either case, the
seller’s bank receives a credit to its reserve account at the central bank. To
summarize, we can say that government purchases lead to reserve credits to the
banking system; tax payments lead to reserve debits. Things can get a bit more
complicated if sellers to government demand cash (bank reserves are debited and
the government provides cash in the mix of notes or coins desired by the nonbank
public), or if the treasury and central bank establish complicated operating
procedures to minimize reserve effects (more below)—but the essentials remain
the same.
If over a year the government’s
spending equals its tax revenue, then there is no net effect on reserves. If
government spends more than it taxes (runs a deficit) then the net effect is to
raise bank reserves. If government taxes more than it spends, then the net
effect is to debit reserves. Note that from inception, government cannot run a
surplus unless it has another method of providing reserves—it cannot debit
reserves that don’t exist! It is commonly believed that if government runs a
deficit, it must “borrow” or “print money” to “finance” the deficit spending.
This cannot apply to a sovereign nation. A sovereign nation spends by crediting
bank accounts, or by cutting treasury checks (which then leads to a reserve
credit when the check is “deposited”). Whether or how much the government
collects as taxes is not relevant to its spending. The implication of a budget
deficit, as we saw above, is that bank reserves increase. Modern sovereign
nations do not “print money”—they credit bank accounts. Nor do they “borrow”, at
least in the manner that non-sovereign entities borrow. One could call a net
credit of reserves to banks a “borrowing” operation in the sense that the
government’s outstanding stock of liabilities (bank reserves) has risen. But
what is the government liable for? It is liable to accept its currency in
payment of taxes; more specifically in this case, it is liable to accept a check
drawn on a bank in payment of taxes, at which time it will debit the reserves of
the bank.
Of course, one might object that
we do observe sovereign nations, like the US, issuing sovereign debt—bills and
bonds. When the treasury sells bonds, bank reserves are debited by an equivalent
amount (directly, if the banks buy the bonds, indirectly if the nonbank public
buys the bonds using checks drawn on bank accounts). Essentially, then, bond
sales merely substitute bonds for bank reserves. Why is this done? We don’t want
to explore the historical or political reasons for such operations, but they
probably derive from operations of nonsovereign governments. The economic
significance of bond sales by sovereign nations is, however, to replace
non-interest-earning reserves with interest-earning bonds (in a few sovereign
nations, such as Canada, reserves already pay interest and hence bond sales
serve no real economic purpose). It is best to think of bond sales by a
sovereign nation as an “interest rate maintenance operation” rather than as a
borrowing operation, because the purpose is to provide an interest
earning alternative to non-earning reserves.
Turning to what is usually called
monetary policy, Post Keynesians long ago recognized that the deposit multiplier
is simply an ex post identity, useless for analyzing constraints on bank deposit
expansion or interest rate determination. All modern economies operate with a
pyramid or hierarchical monetary system. Bank money leverages reserves, or high
powered money (HPM), which is used for clearing accounts among banks and with
the government sector, and for meeting cash withdrawals. The central bank cannot
refuse to provide reserves through overdrafts as needed for smooth functioning
of the clearing system. In addition, the demand for reserves is highly interest
inelastic, so excess reserves rapidly push overnight rates toward zero while
insufficient reserves cause rates to rise rapidly. For this reason, the central
bank cannot allow “market forces” to set overnight rates—it cannot but target
the overnight rate and accommodate all demand at that rate.
Central bank actions are always
defensive, offsetting undesired fiscal impacts on bank reserves, as well as
accommodating any disturbances arising from the nongovernment sector. Fiscal
operations potentially have huge impacts on the quantity of HPM—spending by
government generates reserve credits while taxes debit reserves. Government
deficits equal to 5% of GDP ($500 billion in the case of the US!) would lead to
huge net reserve credits that would generate large excess reserve positions. For
this reason, the treasury and central bank coordinate operations to drain the
excess through new bond issues and open market sales. In a run on an individual
bank, the central bank acts as a lender of last resort to accommodate cash
withdrawals. Most bank runs today take the form of a run on CDs, which only
shifts reserves about, however, should aggregate desired reserves rise in
prospect of a panic, the central bank would necessarily accommodate. There is
simply no plausible reason to believe that a modern central bank would refuse to
supply desired reserves, or that it would leave undesired reserves in the system
(unless, like the Bank of Japan, it has chosen an overnight target of zero). Nor
is there any reason to believe that a central bank adopts “expansionary policy”
by increasing reserves (through open market purchases) as in the deposit
multiplier story. Such activity would simply generate zero overnight rates
until, and if, excess reserves could be absorbed.
The belief that the central bank
can be independent from government misunderstands the interest rate setting
procedure. If deficit spending by the treasury results in excess reserves, the
central bank must drain them through an open market sale. If treasury operations
leave banks short of reserves, the central bank must provide them through an
open market purchase (or at the discount window). The alternative to
coordinating central bank operations with those of the treasury is to leave the
overnight rate fluctuating from near zero (in the case of excess reserves) to
rising without limit (in the case of insufficient reserves). Further, if the
central bank is going to operate a clearing system, it cannot refuse to provide
needed reserves. Is an independent central bank going to bounce treasury
checks? Of course not—indeed, if it ever did, its “independence” would be
eliminated immediately by the legislature of any sovereign nation. Rather than
bouncing a treasury check because a member bank does not have sufficient
reserves, the central bank will always clear the check by loaning reserves to
the bank. Similarly, operating procedures are adopted to ensure the treasury
always has “money in its bank account” at the central bank to “cover” its
checks. These procedures are numerous and can be complex (see Bell and Wray
2003)—the treasury transfers deposits from special tax and loan accounts at
private banks; it sells bonds to special banks that are permitted to buy them by
crediting the treasury’s account without a reserve debit (effectively, “creating
money”); or it might sell bonds directly to the central bank. Ultimately, these
procedures can be adapted and multiplied as necessary to ensure that a) the
treasury can spend up to the amounts authorized by the legislature, b) that
undesired impacts on bank reserves are minimized, c) that the central bank can
hit its overnight interest rate targets, and d) that treasury checks never
bounce.
Let us now go through some simple
balance sheets to demonstrate the most important points made above. First we
will look at the impacts of fiscal policy on balance sheets. Recall that in the
loanable funds model, a government deficit adds net demand for loanable funds,
hence, pushes up interest rates. In the ISLM model, a government deficit will
(except in the case of extreme parameters) raise income and money demand,
raising interest rates in the face of a fixed money supply. However, neither
model can apply to a sovereign nation on a floating exchange rate. In such
countries, government spends by crediting bank accounts and taxes by debiting
them. As discussed above, then, deficits lead to net credits of reserves. Rather
than pressuring interest rates, net reserve credits must—all else equal—push
overnight rates toward zero. We then turn to some of the constraints adopted by
modern sovereign governments.
We will start with the simplest
example, in which government buys a bomb from the private sector by crediting a
bank account. In Case 1A, government first imposes a tax liability and then
purchases a bomb of equivalent value, balancing its budget.[i]
By contrast, in Case 1B, the government deficit spends. This then generates
excess reserves in the banking system that are drained through government bond
sales. Note that in comparison with Case 1A, deficit spending by government does
not reduce private sector wealth, but changes its form from illiquid (bomb) to
liquid (bond).
CASE
1A: Government imposes tax liability, and buys a bomb by crediting an account at
a private bank



Taxes are Paid



Final Position

________________________________________________________________________
Case 1B: Government Deficit Spends



Government Sells Bond

Final Position



Note that we have assumed that
required (or desired) reserve ratios on the newly created demand deposits are
zero, but nothing of significance is changed if we allow for positive reserve
holdings. Government would simply sell fewer bonds since fewer reserves would
have to be drained. It might be objected that Case 1B is too simple because real
world governments often impose upon themselves restrictions that prevent them
from directly crediting private bank accounts. Let us add two extensions. In
Case 2, government must first “borrow” (sell bonds) before it can deficit spend.
In Case 3, we separate the treasury from the central bank, and add a requirement
that the treasury can only write checks on its account at the central bank.
Further, the central bank will be prohibited from “creating money” by making
loans to the treasury, or by direct purchase of treasury’s new issues. It will
be seen that none of these restrictions actually changes anything of
substance—the result is the same as in Case 1b.
Case 2: Government must sell bonds before it can deficit spend

Government Buys Bomb, Writing Check on Private Bank



Final Position



______________________________________________________________________
Case 3: Treasury Can Write Checks only on its Central Bank Account

Treasury Moves Deposit to Central Bank Account



Treasury Buys Bombs




Final Position



Note that in the middle steps of
case 3, when the treasury moves its deposit from the private bank to the central
bank, the central bank must debit the private bank’s reserves. However, the
private bank does not have (excess) reserves to be debited, hence, the central
bank must provide an “overdraft” of loaned reserves. Once the treasury deficit
spends, the bank’s reserves are credited, allowing it to retire the overdraft.
In conclusion, deficit spending by
the treasury leads to a net credit of reserves for the banking system,
regardless of the operating procedures chosen. These are drained through bond
sales (even if the operating procedures require that the bonds are sold in
anticipation of the deficit spending). If this were not done, excess reserves in
the banking system would drive the overnight interest rate down—precisely the
opposite prediction to that of loanable funds and ISLM theories.
What are the implications for operation of an
ELR program? Above we assumed the government is buying “bombs”, that is, output
of the private sector. Nothing of significance would be changed if government
instead bought labor services from the private sector—all the balance sheet
operations would look about the same. So long as the private sector were willing
to sell labor services for money (that is, for credits to bank accounts at
private banks), government would always be able to buy the labor services. In
such a system, there can be no question about the government’s ability to
“afford” such purchases.
None of this should be interpreted to mean that
government should always spend as if “the sky is the limit”, nor to deny that
government deficit spending might have undesired economic effects or might face
political constraints. But the usual arguments—that a big deficit will
eventually lead to default, or to rising interest rates, or to inability to sell
debt to “finance” the deficit—do not apply to sovereign nations. So long as the
private sector is willing to sell goods and services to government, it can
purchase them by crediting bank accounts. Government does not need to sell bonds
to “finance” deficits—rather, as we’ve seen above, bond sales logically follow
deficit spending, and are logically undertaken to drain excess reserves. Indeed,
it is best to think of bond sales as required to maintain positive overnight
rates—at the target rate chosen by the central bank—rather than as a borrowing
operation. Still, it is worthwhile to point out that government deficits might
have an impact on the foreign exchange rate of the sovereign currency. It is
also possible that government deficits might have an impact on the domestic
value of the currency—that is, on the inflation rate. Such considerations should
be taken into account when determining the desired level of government spending.
While this is not the place to pursue this issue, a properly designed ELR
program will not lower the foreign or domestic value of the currency—precisely
because government’s spending on the program will be “market determined” by
labor willing to work at the program’s fixed wage. Our main point of this
article, however, is to argue that a sovereign currency makes it financially
feasible to operate an ELR program that guarantees a job to all job-seekers
willing to work at the program’s “going wage”. On the usual definition, this is
a position of “full employment”.