This is part 5 from the paper “Understanding the Modern Monetary System. To read the first sections please see Part 1 here, part 2a here, Part 2b here, part 3 here & part 4 here. Please feel free to ask questions in the comments or use the Ask Cullen section here. If you’re not familiar with MR terminology you might want to review the glossary here.
Part V – A Fiat System Where Everyone Still Thinks Government Has a Solvency Constraint
The idea that the government does not have a true solvency constraint is shocking to many people. But it’s becoming increasingly well known as the Euro crisis exposes deep flaws for nations that do not issue their own currencies. As I’ve mentioned several times before, there is no such thing as the USA not being able to pay off the liabilities that are denominated in a currency that it can essentially force the banking system (or its central bank) to produce. Warren Buffett recently made this point at an investor conference:
“The United States is not going to have a debt crisis as long as we keep issuing our debts in our own currency. The only thing we have to worry about is the printing press and inflation.”15
How Could It Be Possible That This Myth Persists?
You might ask: “How could it be that this myth of government solvency is so widely misunderstood? How can the brightest minds and the leaders of our country not understand all of this?”
I believe these misconceptions persist due to three primary reasons:
- First of all, this is all highly complex, theoretical and rather undeveloped. Understanding the functions of a monetary system is high finance. We cannot expect everyone to understand it or agree on it and we should expect most theories and outlines of the modern monetary system to be somewhat incomplete due to the dynamic existence of modern economies. Monetary Realism is by no means immune to these flaws and theoretical disagreements, but does use an unusual approach in attempting to be purely descriptive.
- Second, politicians and ideologues have a vested interest in keeping the American public from understanding that the government is fundamentally different from a household, state or business.
- Lastly, most of modern macro is derived from theories that are largely government centric and policy centric. That is, the central power of the money system is always described as resting with the Federal Reserve or the US Treasury and most of modern economics emphasizes policy options as opposed to operational realities. For instance, Keynesians generally believe the money supply can be increased via government spending while Monetarists believe the Federal Reserve can increase the money supply via increases in bank reserves. As MR shows, all of these government centric views of the world are inapplicable to the current design of the US monetary system where banks dominate the money system. A core understanding of operational realities is crucial to understanding how any policy can be implemented and influence the economy.
The True Constraint for a Currency Issuer
Now that we understand that a currency issuer cannot “run out of money” it’s important to also understand that there are real constraints on a government’s ability to influence money. Aside from the obvious constraint of real resources, the currency issuing government’s true constraint is never solvency, but inflation. Inflation becomes problematic when a nation’s spending outstrips productive capacity. This is a real reduction in our standard of living. But it’s important not to confuse some inflation with a reduction in living standards. You might have read that the US Dollar has fallen 90% since the inception of the Fed in 1913. This is true actually. The purchasing power of the dollar has fallen substantially. But this does not necessarily mean the standard of living of Americans has declined 90% since 1913. In fact, living standards have soared since then. How is this possible? Remember, the real benefit of our labor is the time it provides us. Adam Smith once said:
“The real price of everything, what everything really costs to the man who wants to acquire it, is the toil and trouble of acquiring it.”
There is a theoretical level of infinite demand in a capitalist economy. What I mean by this is that, in an extreme sense, we can consume all that time will allow. If you were unconstrained by time you could, in theory, consume all that the producer can produce. Theoretically, this chicken and egg story can go on forever. Of course, the greatest luxury of all is quite finite. We are always constrained by time. The entrepreneur offers us the opportunity to take advantage of the ultimate luxury by giving us more time. We live in extraordinary times with extraordinary technologies that afford us the ultimate form of wealth – time through greater efficiency.
Understanding potential declines in living standards via inflation is about understanding how aggregate supply relates to aggregate demand. Ultimately, inflation is caused by aggregate demand outstripping aggregate supply. And as we will describe later, it’s crucial to understand the balance sheet composition of the economic agents in order to decipher how problematic (or beneficial) this can be. After all, spending in the economy is a function of expected future income relative to desired saving.
There’s No Free Lunch
It’s very important to remember that just because the government does not have a solvency constraint, it does not mean it has no constraint. The bogey here is inflation that is constantly based on the tax rate, spending, borrowing, production, consumption, the money supply, etc. So spending and taxation must always be done in accordance with a nation’s productive capacity so as to avoid imposing undue hardship on the private sector via a reduction in real living standards.
Thus, government cannot just spend and spend or the extra flow of funds and net financial assets in the system could cause inflation, drive up prices and reduce living standards. It’s important to understand that government cannot just spend recklessly. This is important so I’ll say it again. This does not give the government the ability to spend and spend. If they spend in excess of productive capacity or spend inefficiently they can create mal-investment and inflation resulting in lower living standards.
Some people claim that Monetary Realism says budget deficits don’t matter. That is a vast misrepresentation of the position. Deficits most certainly do matter. Maintaining the correct level of deficit spending is, in many ways, a balancing act performed by the government based on an understanding of the sectors of the economy. It is best to think of the government’s maintenance of the deficit like a thermostat for the economy. When the economy is running cold the deficit can afford to be higher. When it is hot the deficit should be lower. Again, someone who understands MR would never describe themselves as a supply sider or a demand sider because the answer is always “it depends”. There are many variables that play into the understanding of whether a government should run a budget deficit, a budget surplus or a balanced budget. MR does not seek to provide policy options, but monetary understandings that make it easier to assess proper policy options.
It’s also important to note that spending by the government must be focused on its efficiency. If spending is misdirected or misguided there is a very real possibility that this spending will simply result in higher inflation that is not offset by increased production. If you pay people to sit on their couches all day long there is no reason to believe why this sort of government policy will not result in long-term economic decline in the citizenry’s standard of living. Living standards, ultimately, come down to the private sector’s ability to produce and innovate. The USA is extremely wealthy not because our government issues financial assets and currency or due to the fact that the banking system issues bank deposits, but because we are an extremely productive and innovative nation. In other words, we are extremely productive with the money that is issued.
With regards to the money supply, it is important that the government maintain a check on private credit. As we have explained, inside money is the dominant form of money. So while government policy can influence the money supply the supply of money is primarily determined by private banks. The government should be a good steward over this extension of credit and attempt to enact policy that supports credit extension, but does not allow it to run wild thereby creating systemic instability or private sector malinvestment.
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