Saturday, 19 January 2013

So what's the catch?

Oh brilliant. I produce a post trying to explain in non-mathematical terms the equivalence of government  debt and interest-bearing money in a fiat money regime. And I immediately get hammered for - variously - writing about the "money tree", playing accounting tricks instead of doing real economics, and inventing a scenario where no-one ever has to pay taxes and governments just print endless amounts of money. How on earth my critics managed to deduce that lot from my post I don't know, but I will at least address the last of these, which is the only serious point. I was awfully tempted to ask my "economics" critic to define "real economics".....

Anyway. let me explain. No, I did not, and do not, suggest that governments can just print money ad infinitum to meet their spending obligations. And no, I did not, and do not, suggest that no-one needs to pay taxes. On the contrary.

Taxes are ESSENTIAL in a fiat currency regime. The value of the currency - and of the associated debt (since interest-bearing government debt is simply a stream of future private sector money claims) - depends on the government's ability to tax its population. If it can't then fiat currency is worthless - and by extension, so is debt. Which is why every recorded example of hyperinflation (when fiat currency becomes worthless) is associated with severely dysfunctional government, social chaos and - often - regime change, usually following a severe POLITICAL shock such as losing a war. A dysfunctional government can't tax its population: a traumatised and angry population can't be taxed. Hyperinflation is primarily a political phenomenon.

Those of you who were hoping that my endorsement of money issuance as a means of meeting government spending commitments meant that I was coming round to the idea of higher spending commitments unsupported by additional production and/or taxation are going to be disappointed, I'm afraid. I haven't converted to your cause. I stand exactly where I did before - increased government spending must support, or be supported by, increased production in the real economy, OR it must be supported by higher taxes - which must be subject to democratic approval. If it is supported neither by increased production nor higher taxes, then it will be unsustainable however it is funded.

The same fiscal discipline needs to be applied whether governments choose to meet their spending commitments by creating money or issuing debt. THERE IS NO DIFFERENCE. Money printing is NOT an opportunity to do things that you couldn't do if you had to borrow the money. The horror we have of money printing arises from those few times in history when governments have met spending commitments by printing money without the necessary fiscal discipline, and the result has been inflation. Someone asked me whether Zimbabwe's behaviour undermined my argument that governments can meet their spending commitments through money issuance without it being inflationary. But my argument was that RESPONSIBLE governments can meet their spending commitments through money issuance, just as RESPONSIBLE governments can meet their spending commitments through debt issuance. Zimbabwe had an irresponsible, inept and malicious government that was hell-bent on trashing the only significant industry - agriculture - to further its political ends. It couldn't raise money through debt issuance, because no-one in their right minds would lend to it, so it printed the money instead. How this undermines my argument is a mystery to me.

So money printing is not a free lunch. There is a catch, which is that it has to be supported by production and taxation. Just like debt.

What is really depressing is that the post wasn't even about money issuance. It was about the role of debt in a fiat money regime, and the importance of government acting as a savings bank for its citizens. Somehow that got lost in all the money printing hysteria.

I hope this is all nicely clear now.

Related post: Government debt isn't what you think it is

24 comments:

  1. dont back down; your previous post was important and will lead my emailed sunday selected links (without the "catch")...we cant convey these ideas often enough in the face of rhetoric from the deficit scolds...the endgame is to shift the overton window...

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    1. Thanks! I've no intention of backing down. Though it was particularly harsh that one of the critics was my brother. We don't exactly agree on these things.

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  2. How many times did people ask well give everyone a million and we all be rich? oh if I had a penny for the times I have had that comment really would be rich :)

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  3. Here's a link for the laggards that couldn't understand your first post:

    https://www.youtube.com/watch?feature=player_embedded&v=4bXpOUYrr1c#!

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  4. Frances,

    Your posts come down to telling a story about the unlimited ability of the government to borrow. Unfortunately, in an open economy, the government doesn't have it. So nations have a balance of payments constraint and this is superstrong. A fiscal expansion brings in an increase in output but at the same time has an adverse effect on trade. If a nation puts up fiscal policy to increase output, then its public debt and the net indebtedness of all resident sectors to foreigners keeps rising. The rise in the public debt will be a counterpart to the rise in net indebtedness of the nation to foreigners.

    An external constraint is not just that due to inflation brought about by a depreciation of the exchange rate which may sometimes be low. The constraint is a debt constraint. If the net indebtedness of a nation (the negative of "net international investment position") rises a lot there are all sorts of problems in the foreign exchange market.

    So for a debtor nation, fiscal policy gives in and one has to play other tricks. So nations play the "Beggar My Neighbour" game in which they try to reach higher exports via four methods - which Joan Robinson (the originator of the phrase) called fours suits from a card game. Even the creditor nations start playing the game.

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    1. Hi Ramanan,

      Balance of payments and currency risk is for the next post! We don't pay enough attention to it nowadays. I'm aware that the "external" side of this post is much weaker, though I did briefly discuss what happens when external indebtedness is too high.

      What I was trying to do in this post was describe the role of government debt in a fiat money economy where government does not need to borrow and debt & money are equivalent. That followed on from recent conversations I've had with people who think governments should simply stop issuing debt and meet spending commitments through money issuance only. I disagree with them - I think debt has a considerable role in the DOMESTIC economy. And I was also attempting to resolve the apparent conflict between the need for safe assets and concerns about indebtedness that I've been discussing recently. That's more problematic and I'm aware that I haven't addressed all the issues.

      This post follows on from my last one (hence the links), and I haven't finished with the subject yet.

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    2. Here's one from me:

      http://www.concertedaction.com/2013/01/19/the-beggar-my-neighbour-game/

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  5. Nope it's not quite clear. I think you could devise a fiat currency that is stable and where there are no taxes in the common sense. Simply use gov spending for increasing the supply and monetary means (neg real rates if need be) to sponge up any above target inflationary excess. You still need responsibility, but it should be doable. Arguably this is just a situation where 100% of taxes are savings taxes, which hints at what your correspondents need to understand: taxes and monetary policy are really one and the same thing, the same way as gov debt is the same thing as issuance. It's not gonna be easy but the full argument is perhaps more understandable than only one half.

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    1. "taxes and monetary policy are really one and the same thing"

      wow. Thanks Cig, that is a really interesting remark. It implies we have created a totally artificial distinction between monetary and fiscal policy. I've noticed the blurring of the edges between the two when rates are very low - for example I've suggested using Pigouvian taxes to discourage use of physical cash in a negative-rate economy. And there is a growing view that fiscal and monetary policy coordination is essential: there was a very interesting paper from McCulley and Pozsar on that subject recently. But your comment takes us a lot further. I shall ponder on it!

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  6. " Taxes are ESSENTIAL in a fiat currency regime. The value of the currency - and of the associated debt (since interest-bearing government debt is simply a stream of future private sector money claims) - depends on the government's ability to tax its population. If it can't then fiat currency is worthless - and by extension, so is debt. Which is why every recorded example of hyperinflation (when fiat currency becomes worthless) is associated with severely dysfunctional government, social chaos and - often - regime change, usually following a severe POLITICAL shock such as losing a war. A dysfunctional government can't tax its population: a traumatised and angry population can't be taxed. Hyperinflation is primarily a political phenomenon."

    I agree with you that hyperinflation is caused by loss of faith in government. Hyperinflation is a rejection of the money issued by that government. The relative value of a fiat currency is derived from the confidence people have in the issuer. However, I disagree with the chartalist theory that we accept fiat money has value because we can extinguish tax liabilities with the fiat currency. There are many examples where people accepted fiat currency having value even though it was not legal tender or useful to pay taxes. John Kay wrote an interesting article last year on the subject.
    http://www.independent-investor.com/articles-by-markets/money-like-hat-wearing-depends-on-convention-not-laws/

    Consider the Gulf rupee that circulated as a medium of exchange in Kuwait, Bahrain, Qatar, the Trucial States for seven years. The Reserve Bank of India issued the currency, but the GR was not legal tender in India and it had no taxation use. The people using the currency simply found it useful as a means to engage in transactions.
    http://en.wikipedia.org/wiki/Gulf_rupee

    The United Arab Emirates has no taxation and the current UAE dirham still has value.

    Social convention helps to explain why we value fiat currency as a medium of exchange. The simple reason why we believe our fiat money has value comes down to simply believing that other people will accept it has value. Our belief really is based on what we believe other people will think. That belief has disappeared in a hyperinflationary environment and people reject the currency because they know others will also reject the currency.

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    1. Ah. More subtle than I thought. Isn't it all related though - a people that has lost faith in its government can't be taxed? So maybe I have the direction of causation wrong here. Would you say that fiat currencies depend on government being credible, of which the most common (but not the only) expression is their ability to tax?

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    2. Though I did point out that fiat money has to be supported by production, too. Hyperinflation is also associated with catastrophic production collapse. It would be possible for a highly productive economy to have no taxes and still a successful fiat currency, just as it is possible for a highly productive country to have no debt. I suspect the only ones that manage either of these are those with abundant natural resources - except for tax havens where low or no taxes are part of their competitive strategy, of course. It's interesting that both the examples you give are oil-producing countries.

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  7. Morning, was bemused reading your latest blog post. I'm not sure I grasp the concept that there is such a thing as 'real' economics or quite what the fuss is about. I wonder if an analogy would be the difference between pure and applied maths. Certainly proper accounting seems to give a truer picture of the world than a lot of economics and by my reckoning economists need accounting more than accountants need economics.

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    1. I think my critic was suggesting that my post didn't contain any economics he agreed with!

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  8. Interesting articles, Frances. Thanks.
    From cig, "I think you could devise a fiat currency that is stable and where there are no taxes in the common sense". Agree.
    I think, we are moving towards that kind of society slowly. The pace depends on how quickly our technology or Frances's production capability makes progress: AI, organs on-demand, intelligent robots,Singularity or indefinite longevity etc. If you have huge productive capacity, money-printing is less an issue.

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    1. Thanks. That ties in very nicely with the recent debates (Krugman, Harford, Kaminska etc.) on the future of production and the rise of robots. If production is unlimited and cost-free there need be no taxes in the normal sense, though we would still need to tax rents - in fact taxing rents would become far more important than it is at present, since most people wouldn't have earned income as we understand it today.

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  9. Hey Frances,

    I think I agree with a lot of what you are saying, but I don't see why taxes are essential in a fiat currency regime. Recently, I've been arguing almost the opposite, namely that, post-gold-standard, taxation doesn't even make much sense. The government, as issuer of its own currency, could simply spend money into existence and avoid the bureaucratic mess of chasing citizens (and indeed corporations) down one-by-one in order to retrieve that which it has the power simply to create. The value of a currency depends on the power of its issuer -- the power to play the tax game (almost a kind of ritual, I'm increasingly inclined to believe) is simply one manifestation of that power. The ability to call citizens to war is another manifestation (levying a certain kind of labor). The power of the currency issuer, in turn, reflects (in part) the power of the people controlled by that currency (citizens, roughly speaking) to produce things of social value (goods and services). I can't see how taxation is anything more than a particular kind of governmental strategy; if it is preferable to direct issuance, this is due to historical contingencies.

    The common wisdom that hyperinflation historically has resulted from excessive money printing might not hold up; I think this might align with part of what you said, that hyperinflation is primarily a political phenomenon. Michael Hudson from UMKC (MMT crowd), and others, have argued that, for example, Weimar hyperinflation actually preceded Weimar hyper-money-issuance, and that hyperinflation in most cases results mostly from unfavorable terms of trade, often connected with massive(ly unrealistic) debt/ war reparations. Hudson makes the argument in a few places, notably in the second volume of "Trade, Development, and Foreign Debt," a book (one of my favorites) that is a lot more readable and fun that its name would suggest.

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    1. The causes of hyperinflation are pretty much firmly established now - they are collapse of production capacity and effective government, usually associated with some kind of exogenous traumatic shock such as a war. Money printing is a symptom of hyperinflation, not the cause.

      I disagree with you almost entirely about taxation, I'm afraid. Taxation is a contribution to society, it is "giving something back", if you like. And it is the primary vehicle by which resources are redistributed - obviously philanthropic giving is another, but it actually isn't as effective as a well-functioning system of taxation. Your argument that government can simply "create" money for these purposes won't wash: it is resources that need to be redistributed, not money. Creating money without any relation to resources IS inflationary.

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    2. In theory a collapse of production capacity need not produce hyperinflation, the central bank/treasury could viciously shrink money supply accordingly to balance. It's just that it's often not politically expedient to do so in those conditions, in all the well know cases like Weimar and Zimbabwe the government paid people who did not produce anything (Ruhr workers, Zimbabwe's soldiers and public sector non jobs) cumulated with buying foreign currency at any price to pay foreign debts/reparations.

      On taxes, many of them can be eliminated without changing anything to the economics: it is the same to pay a public sector employee 20k tax free as it is to pay them 30k gross and then have them give back 10k in taxes. Why bother with the taxes then and not simply pay net tax free amounts? Similarly private sector suppliers of the state could be paid net prices, and only have their income from private sector clients taxable.

      As for redistribution you can implement a lot of it by positive stipends rather than taxes, or by making government services means tested (e.g. charge a road usage fee to people with big cars, is that a tax?). The "contribution to society" idea is intact: resources are redistributed from people who get zero stipends and pay a lot on services to those who don't.

      I mean a bit of old fashioned tax is probably worth keeping for cases where it's the most convenient mechanism administratively, but it's not as such essential in principle, and it would be nice if people could understand that net numbers is what matters and that tax credits are perfectly symmetrical with debit taxes. The lack of understanding for this is probably why it'd be hard to pay public sector employees tax free, the private guys will see it as an advantage even if the "tax free" salaries are calibrated on the after-tax private wages for similar activities.

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    3. Hi cig,

      This taxation debate is fascinating. I understand the netting principle - for example I know interest paid on government debt holdings by taxpayers is effectively a tax credit. I agree about the political issues around paying public sector workers net of tax - there is enough rubbish spouted already about public sectors being "paid more" than private sector ones. But in a world where a high proportion of people receive some kind of benefit, perhaps we need to start looking at net rather than gross tax figures much, much more. At the margin, net negative taxes effectively pay people not to work....

      In theory I can see the argument of the "we don't need taxes" brigade in a fiat-money economy - taxes make no overall difference, because all they do is move savings from the private sector to the public sector. But I think there is a need for taxes as a brake on the tendency of both external deficits and unproductive savings to rise. And I keep coming back to the production link: unlimited government spending on unproductive activities with no tax brake is indeed Weimar, or Zimbabwe....I need to think about this more, but I'm beginning to understand your point that in a fiat money economy taxes are monetary policy.

      All the examples I have seen of net zero tax countries with fiat money have either been disasters or have had very large external sectors (oil producers, tax havens). In which case government spending is actually redistributing the proceeds from the external sector back into the economy, and government services are being paid for by foreigners.

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    4. Totally agree you need a brake. The point is you could get that brake with means other than debit taxes, at least in theory. The main point is pedagogical: if someone has understood that, they've made a quantum leap in their ability to understand macroeconomic problems compared to someone who hasn't. So much of the macro-economics debate is bogged down in arguing about a quirk of a given tree that has no relevance to forest management...

      Abolishing taxes is probably impractical enough for a big state but it would be fine for a small central state, for example the ECB could be funding direct (the eurozone share of) the 1% of EU GDP Brussels costs with no problems at all.

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    5. Monetary brake is definitely an alternative, and arguably a better one - as the "monetary dominance" argument in neoclassical economic circles suggests. If the central bank is effective, governments CAN'T ramp up spending sufficiently to cause inflation, because central banks will always choke it off. That applies irrespective of the method of funding of government spending. For hyperinflation to take hold, therefore, both government AND central bank have to be ineffective. So it doesn't really matter whether you use monetary policy as a brake or fiscal policy (taxation).... they are the same thing.

      I think if people could understand that all taxes are actually taxes on savings it would help. People really don't like their savings to be taxed.

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  10. Would you agree Frances that money issuance has the significant advantage over debt issuance of not coming with interest payments attached?

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