By Dan Kervick, a PhD in Philosophy and an active independent scholar specializing in the philosophy of David Hume who also does research in decision theory and analytic metaphysics. Cross posted from New Economics Perspectives
I have set out a simplified model of a monetarily sovereign government. But near the end of the previous section, I began to suggest that the United States government is indeed a monetary sovereign by this kind. The reader might now suspect that I have yielded my rational mind over to a simplistic fiction of my own creation. And by this point, the reader is probably thinking that however interesting it might be to imagine this fictional entity, the so-called monetary sovereign, such fictions have nothing to do with the complexities of the real world, because actual governments maintain accounts that are indeed constrained by the amount of money in those accounts and by the external sources of funding to which they have access. After all, can’t a government default on its debt? What about the recent debt ceiling debate in the US? What about what is happening in Europe with the sovereign debt crisis? Also, if a government like the United States government was a monetary sovereign of the kind I have described, the consequences would seem to be enormous. Surely if a democratic government possessed this kind of power, we would make much more use of it than we do. In short, monetary sovereignty as described seems both too simple to be real and too good to be true.
These skeptical intuitions are reasonable, so they need to be addressed. First, let’s consider the question of whether monetary sovereignty is too simple to be real.
I will argue that the government of a country like the United States is much closer to the ideal of monetary sovereignty than the typical citizen recognizes. To theextent the model is overly simplified, that is due entirely to choices we have made about how our government should be organized internally. The financial and monetary operations that occur in our actual government are not carried out by a single operational center, but rather involve several parts of the executive branch, most prominently the Treasury department. Congress is involved as well, as is the Federal Reserve System. These branches of the government are subject to various legal restrictions and constraints. But these are all constraints that the country’s legislators have chosen to impose on the government’s financial operations. They are to that extent voluntary and could thereforebe altered.
Congress has chosen, for example, to make the US Treasury,and even Congress itself to some extent, function as a currency user rather than a currency issuer, and has attempted to assign to the Fed all primary responsibility for direct decisions over the increase and decrease of the money supply. Ultimate monetary authority obviously resides in Congress, but Congress has delegated much of that authority to the Fed, and has been reluctant to exercise the authority directly by engaging in direct monetary operations on behalf of the public it represents.
These restrictions have been implemented in several ways: The Treasury Department can only spend if there are sufficient points on its monetary scorecard – that is, if sufficient dollars are credited to its bank accounts. Its accounts are held at the Fed and administered by the Fed. It is forbidden from overdrawing its accounts at the Federal Reserve, and the Fed has no authorization to credit those accounts directly and unilaterally. So the Treasury can’t create money itself by a direct act, in the course of its ordinary operations, nor can the Fed create it directly for the Treasury. If Congress has authorized some spending by the Treasury Department, the Treasury can only carry out that spending if the combination of tax revenues and borrowed funds currently supplying Treasury accounts constitute sufficient funds for the spending. If tax revenues are insufficient, then in most cases the Treasury Department will sell bonds to theprivate sector, and raise funds in that way. However, Congress has also imposed a debt ceiling on Treasury borrowing, so the Treasury’s prerogative in issuing bonds is capped.
The Treasury Department does possess, through its operation of the US Mint and as a result of certain loopholes in existing authorizationsto mint coins, a potential source of direct control over monetary operations. But taking advantage of these loopholes would be highly unusual and politically controversial. And if Congress remained determined to keep delegated monetary authority with the Fed, then the loopholes would probably be closed quickly by legislation.
Also, the Treasury Department is forbidden from selling bonds directly to the Fed. So while the Fed is permitted to create money and use it for making loans to banks in the Federal Reserve System, or for the purchase of financial assets from private sector owners of those assets, it cannot purchase bonds directly from Treasury. And thus the Treasury cannot borrow directly from the Fed. The two departments must instead follow a more roundabout method. The Treasury can sell bonds to private sector dealers in an auction, as it ordinarily does. The Fed can then, at its discretion, purchase those bonds from the private dealers in separate auctions. Treasury ends up with some amount of borrowed funds, but also with a liability to pay the Fed the principle on the loan. Any interest payments on the bonds will be returned to the Treasury, since the Fed is not permitted to collect interest from the sale of Treasury bonds. So the Treasury ends up in a better position than if the bonds were still owned by the private sector dealer. But the Treasury still owes the Fed the principle. How these loan payments are funded is then ultimately up to Congress to decide.
Let’s conduct a thought experiment, and imagine how things might work if the Treasury could sell bonds directly to the Fed, and if Congress exercised more direct supervision over the Fed’s purchases of Treasury dept.
Suppose the Treasury Department were permitted to issue a special class of bonds – call them “M-bonds”. These bonds could not be sold to private sector purchasers on the open market, but could only be sold to the Fed directly. Suppose that the bonds carried no coupon payments and 0% interest, and matured in a year. In other words, if the Treasury sells a $1 billion M-bond to the Fed today, then the Treasury receives $1 billion from the Fed today, and next year they pay the Fed exactly $1 billion, with no interest payments in between.
Suppose also that the Fed were not permitted to refuse to buy M-bonds. Let’s imagine that Congress has passed a law mandating that, if Treasury issues an M-bond and offers it for sale to the Fed, the Fed has to buy it. But let’s also assume that Treasury is still not permitted any overdrafts on its account at the Fed. Congress continues to mandate that any Treasury spending must be cleared through its Fed account, and that the only ways of funding that account are though tax revenues, sales of ordinary Treasury bonds to the private sector and sales of M-bonds to the Fed.
Now, finally, let’s suppose that the Treasury Department has a standing policy of funding $100 billion of public sector spending each year through the sale of M-bonds. It also hasa policy of issuing new M-bonds each year to meet the full costs of servicing its outstanding M-bond debt. In other words, it always pays the debt it owes on its M-bonds just by selling more M-bonds. So, in Year One it sells the Fed $100 billion of M-bonds, and spends the proceeds. In Year Two, it sells $200 billion of M-bonds, spending $100 billion of the proceeds and using the other $100 billion to pay off the Year One debt. In Year Three, it borrows $300 billion, spends $100 billion and uses the remaining $200 billion to pay off the Year Two debt. Etc.
We can see that the portion of Federal debt attributable to M-bond issuance grows arithmetically by $100 billion each year. So the national debt continues to rise. But we can also see that that portion of the debt is relatively meaningless. And it wouldn’t matter if M-bonds were not sold at 0% interest, but carried some positive interest rate – say 10% or more. In the latter case, the debt due to M-bonds would not rise only arithmetically, but would rapidly compound. But it would be just as meaningless, since the whole quantity of the previous year’s M-bond debt would be borrowed from the Fed each year, and then paid back the next year with additional borrowings from the Fed. The Fed would be required to purchase this additional M-bond debt each year, so the rising debt places no rising burden on the US Treasury or the American taxpayer.
It should be clear at this point that the entire functional effect of all that borrowing and repayment with M-bonds could be accomplished by the following simpler alternative operation: Congress simply mandates that each year that the Fed must directly credit $100 billion to Treasury Department accounts at the Fed. No bonds. No borrowing. End of story. While this might appear to be an entirely different kind of operation, ultimately they are just too different mechanisms for accomplishing exactly the same effect. Thus, the rapid arithmetical rise in M-bond debt in our thought experiment is not functionally equivalent to a cycle of hyperinflationary runaway money printing. There is instead a fixed, modest annual amount of net money creation – $100 billion, which is just a fraction of annual US GDP – and the ballooning debt payments are just an artifact of the convoluted M-bond method Congress has hypothetically prescribed in our thought experiment to accomplish this money creation. The M-Bond debt owed by the government to the Fed – which is itself part of the government – has a fictional quality.
It is vital to recognize, then, that the third party private sector involvement in the current borrowing relationship between the Fed andthe Treasury is entirely voluntary on the part of the US government. Congress could remove it at any time, simply bypassing the appropriate legislation.
Congress could also, at any time, direct the Fed to credit Treasury Department’s accounts – their monetary scorecards – by any amount Congress seesfit. The recent debt ceiling crisis,therefore, is entirely the result of self-imposed, voluntary government constraints. The government can never runout of money unless it chooses to subject itself to various self-imposed constraints.
Congress has not provided itself with any institutionalized means for conducting monetary operations directly, and has imposed on both itself and the Executive Branch – the two political, elected branches of the government – a system that requires both branches to act as though they are the mere users of a currency that is controlled by the Fed. Congress has thus imposed a quotidian accounting constraint – to use a term introduced earlier – on the political branches of government. The Fed, on the other hand, is effectively permittedto spend without a scorecard. But its spending options are limited by law: It can buy government bonds and other bonds on the open market. It can also lend funds to banks at a rate ofits own choosing. But it can’t buy a battleship, or hire 100,000 people to spruce up the national parks or build ahighway or rail line, or simply send checks to selected American citizens. Or at least if it tried to do these things it would likely be challenged legally for conducting operations that appear to exceed its intended legal powers. Just what theactual limits of those powers are, and how much Congressional spending power has been delegated to the Fed, seems to be a matter of some controversy. But it is clear that the Constitutional intention is that the “power of the purse” is supposed to reside with Congress. And thus any move by the Fed to begin conducting fiscal policy byspending money on all matter of goods and services would be extremely controversial to say the least.
It sounds a little bit strange, of course, to say that Congress has imposed operational constraints or restrictions on itself in the area of monetarypolicy. After all, apart from thosesupreme laws that are embedded in the US Constitution, Congress makes the laws. So in what sense can Congress beconstrained by laws of which Congress itself is the author and master? We might think here of the ancient Greek hero Odysseus, who had himself bound to the mast of his own ship to prevent his ship’s ruin on the rocky island of the Sirens. But the important thing to remember in this area is that while the US Congress might be bound by laws that Congress itself has created, these laws can be changed at any time by the same Congress that enacted them. Congress can intervene in US monetary operations at any time, since US monetary power is constitutionally vested in Congress.
So the parts of the government that can actually accomplish a lot with their spending – Congress and the Executive Branch – are presently required by law to act as mere currency users that must draw on private sector funding sources to carry out that spending, while the part of the government that is permitted to act as a currency creator – the Fed – is subject to fairly strict limits on what it can accomplish and whom it can affect with that spending.
The whole system seems cumbersome and byzantine when viewed in this light. But perhaps the seself-imposed constraints have important policy justifications? Perhaps Congress in its wisdom has seen that monetary power is simply too dangerous for direct democratic governance, and that even Congress itself cannot be trusted to carry out monetary operations inconjunction with spending and taxing operations, in a democratically influencedfashion? We will return to this question later. But for now, let’s turn to the other instinctive reaction to the model we have developed of a monetarily sovereign government: that it is too good to be true.
If the monetary sovereign is not subject to any operational requirement either to tax or to borrow in order to spend, and if the monetary sovereign has the power to create money at will, then isn’t that the ultimate free lunch? Doesn’t that mean that a government of this kind can spend without limit either to purchase goods or services for the public sector or to effect direct transfers of monetary bonanzas to private sector accounts?
We all know something is wrong with this suggestion, if we interpret it in its most obvious sense. And where it goes wrong is in its loose use of the word “can”. Of course, in one sense the monetarilysovereign government can spend without limit. There is no operational constraint on this spending. The US Congress can authorize as much spending as it desires, and of almost any kind. It can, if it chooses, permit that expanded spending to go forward in the absence of any additional taxrevenues. It could remove the debt ceiling and authorize, or even direct, unlimited borrowing by the Treasury. Or it could direct the Fed to credit the Treasury Department account directly with some large amount of money. It could even eliminate the Treasury Department’s Fed account entirely, and simply direct the Fed to clear any check issued by the Treasury Department, and always make a payment directly to the account of whatever bank presents that Treasury check to the Fed.
In the purely operational sense of “can”, our government can do all of these things. But we all know that under many circumstances, such actions could have very bad effects. In addition to whatever operational constraints do or do not bind government actions, there are also what we have called policy constraints. A policy constraint on government actions is simply a policy choice the government has made that cannot be effectively carried out if the government does not act within that constraint. And if the policies are sensible ones, thepolicy constraints are sensible as well.
One such policy which most governments seek to implement isa price stability policy. For good reasons, governments seek to prevent prices on goods and services from rising or falling too much in a short period of time; or from rising or falling sharply and suddenly, or in an accelerating fashion; or from behaving in an erratic and unpredictable manner. Price instability of these kinds can have an inhibiting, recessionary effect on economic activity, as the participants in the economy struggle to predict the outcomes of their medium-term and long-term contracts and transactions. If a monetarily sovereign government suddenly authorizes the creation of excessively massive amounts of new money, and simply spends that money into the private sector directly to make public sector purchases, or transfers it to individuals who in turn spend it, the effect could be a sharp and sudden surge in the level of prices. High inflation and shortages of goods are the likely result.
And yet the risk of runaway inflation as a result of government money creation is frequently exaggerated. Some commentators seem to assume that the merecreation of new money will always have a corresponding inflationary effect, no matter how the new money is spent. Theyare constantly warning is that “hyperinflation” is just around the corner as aresult of government money creation. But this inference does not meet the test of either common sense or considered examination. Adding money to the economy only exerts pressure on prices if that money is in the marketplace, in the hands of customers, competing with other potential customers for goods and services to bid up the prices of those goods and services. If the money is inserted into the economy insuch a way that it mostly goes into savings or bank reserve buffers, it will not contribute to price pressure. Such appears to be the case with recent “quantitative easing” policies pursued bythe Fed.
But even if the money does accompany hungry customers straight into the marketplace in pursuit of goods and services, it still might not exert much pressure on prices. It really depends on how and where the money is inserted. Consider an economy like the one we are enduring currently, with double-digit real unemployment and substantial underutilized human and material resources. Many businesses are experiencing empty shelves, unused warehouse space, vacant office space, idle productive machinery and internal systems operating well short of their capacity. In response to a surge in demand from new customers with money to spend, such businesses can ramp up production rather quickly. They can hire workers from among the huge army of unemployed people hungry for jobs, put productive capacity back online, and fill up existing shelves or distribution facilities with very little additional cost per unit of output. In fact, with so much underutilized capacity, the cost per unit of output sometimes even falls with additional production, as current capacity is used more efficiently. So businesses would have little reason in these circumstances to raise prices on the basis of cost pressures alone. At the same time, any business that is even tempted to raise prices in response to the new demand would face intense pressure from their competitors, who have been starved for customers throughout the recession, and who will be only too happy to keep prices low and reap increased revenues from boosted sales alone, with the same unit production costs, and without attempting to frost the tasty new cake with an uncompetitive price increase.
So, inflation fears vented over proposals for more government deficit spending assisted by sovereign monetary power are often overblown. An economy in a deep recession like ours would likely benefit greatly from such a direct expansion of government spending.
In fact, not only is government spending in a recession likely to be beneficial, but the decision to throttle down government spending and reduce deficits – that is, the decision to practice austerity – is positively harmful in the same circumstances. That is because, in the absence of any change in a country’s current account status with respect to its trade abroad, any decrease in the government deficit corresponds to an aggregate worsening of private sector balance sheet positions. If the government insists on pushing its own balance sheet into a position of surplus, it will likely push the private sector into a deeper deficit, which is precisely the wrong thing todo as the private sector struggles to deleverage, and as household and business incomes fall. And in the context of a global recession, where virtually every country would like to increase exports significantly but few countries can do so because there are not enough foreign buyers for their goods, the clear present need is for expanded public sector spending.
But suppose our government chose to expand spending by making use of additional borrowing from the private sector? In that case, the additional deficit spending would drive up the national debt. Isn’t there great risk in these high debt levels? If the government’s debt goes to 100% ormore of our entire annual national product, isn’t that dangerous? Many pundits are warning these days about the allegedly calamitous level of debt and the threat of ruin or bankruptcy governments face as a result.
And private sector debtis certainly a big problem. As we have discussed, individuals, households and firms – unlike monetarily sovereign governments – are mere users of debt instruments and monetary instruments they don’t control, and operate under real and inviolable budget constraints. They can face insolvency if their debts gettoo large. And even if they are not in immediate danger of insolvency, high debt burdens place serious limits on the ability of private sector borrowers to spend their income on satisfying other wants and needs.
Politicians have recently drawn on these fears of private sector debt in the United States to elevate similar fears about the debts of the US government. We hear politicians and other national opinion leaders warn that the government faces “bankruptcy”. They say that it is “broke” or “out of money”. And they are exploiting these fears to pressure Americans to reduce the size of their public sector spending,and grant even more power to the private sector firms that helped steer us intoour current crisis. But the claims behind these warnings about government debt are often downright false. At best they are often wildly overblown, and based on significant misunderstandings about how our government’s monetary system operates, and how any monetarily sovereign government relates to the world ofprivate sector finance with which it interacts. Here are several facts to bear in my about federal government debt in the United States:
First, the US government, as a monetarily sovereign nationthat is the monopoly producer of the US dollar, can face no solvency risk otherthan a voluntary, self-imposed solvency risk. The US borrows in dollars, a currency that the US government itself controls and produces. The US government therefore simply cannot go bankrupt and fail to pay its debts unless the US Congress chooses to prohibit the Treasury Department from paying those debts, by choosing to prohibit the Treasury from making use of the inherent monetary power of the United States. Now this is in fact what the US Congress threatened to do in the summer of 2011. That is not because the government faced an externally imposed solvency crisis. It is because some members of Congress chose to manufacture a crisis by threatening a voluntary default, in order to blackmail American citizens and other members of Congress into reducing the size of public sector spending.
It is true that the Treasury Department is currently constrained by Congress to sell its bonds to private sector lenders. But that is again an arrangement that Congress has chosen. At any time Congress could enact legislation permitting direct borrowing from the Fed –effectively creating what I called “M-bonds” – or direct the Fed to credit the Treasury Department’s account by any amount Congress desires, including whatever amount might be necessary to pay any existing debt liabilities. So there is simply no risk of US government bankruptcy other than the risk that the US Congress might, somewhat recklessly and fanatically, choose to default on US government debt.
The only real constraint that needs to be born in mind in the area of government borrowing is the policy constraint of price stability. Once economic activity returns to full capacity, the need to preserve price stability will require that government debt liabilities to the private are met through processes that begin to remove compensating monetary assets from the non-governmental sector through taxation rather than processes that continually expand those monetary assets through more central bank purchases of debt. Most of that transition will occur automatically. As economic growth returns and incomes rise, tax revenues will automatically rise along with the incomes.
Some worry about the size of the debt we owe to foreign lenders, including foreign governments. The Chinese government, for example, currently possesses over 9% of US treasury debt. Politicians use this fact to portray the Chinese as a potentially oppressive creditor that could choose to “call in our loan” and drive us into insolvency or crisis. These fears are also overblown. When the Chinese or others purchase US treasury debt, they purchase it with dollars – dollars they already possess. There are only so money things you can do with a foreign government’s currency you possess. One of those things is to buy bonds from that foreign government (or save it with a financial institution that is itself buying government bonds). A bond issued by the Treasury Department functions as the equivalent of an interest bearing savings account for people with dollars to save. If the dollar holding foreign nation chooses not to put their dollars in “savings” by purchasingbonds either directly or indirectly, they will have to keep their dollars in “checking” by leaving them in bank accounts earning lower interest. Why would they do that?
Suppose the Chinese decided they no longer wanted to purchase US government debt. What would they do with their dollars? Their only real alternative would be to exchange those dollars for something else. That is, they could buy something with the dollars in markets where the dollar is accepted – primarily America. At that point, it is hard to imagine the media screaming, “Crisis! Chinese seeking to buy massive amounts of American goods!”
Under current arrangements, as we have seen, the Treasury Department is constrained to sell bonds on the private market. So the fear might be that even if the Fed is prepared to buy up as much Treasury debt as is needed in order to support Treasury spending operations, the Fed might not get that option if skittish private sector borrowers refuse to buy government debt at high prices. Again, the problem with this line of thinking is that the entire world that does business in dollars has no otheroptions but to save its dollars in savings vehicles that are in one way or another founded on government debt liabilities. The Fed exercises tremendous control overinterest rates through its open market operations. So realistically, there will always belenders ready to purchase bonds that the government issues, at the interest rates we desire, so long as the Fed stands ready to purchase as much government debt as needed to set the interest rates its desires to set. Borrowing costs for the US government remain extremely low, despite the warnings of those who fear federal government debt is too high. Nor do people in other countries seem any lessinclined to save and do business in dollars. The dollar is currently very strong on world currency markets, despite persistent warnings by the fear mongers that government money creation will lead to a hyperinflationary loss of value in the dollar.
Some of those who spread fear about dramatic inflation or hyperinflation resulting from government money creation point to the recent rounds of “quantitative easing”, in which the Fed purchased large quantities of financial assets on the private market. Since the Fed effectively creates the money on the spot that it needs topurchase those assets, some fear that this massive program of purchases has flooded the economic system with money, and the pressures from this deluge will eventually lead to a runaway rise in prices. But it is important to recognize that when the Fed buys financial assets, that purchase amounts to a removal of money from the economy over time as well as an insertion of money in the present.
Suppose that some private sector entity A possesses a bond issued by some other entity B, where B can be either the Treasury Department orsome private sector lender. Suppose that the bond commits B to the payment of $10,000 to A over the next five years, on some pre-determined schedule. Now suppose that the Fed offers to purchase this bond from A for $9000, and that A decides to sell the bond because A prefers the $9000 now to the delayed receipt of $10,000 over five years. It is true that when the Fed makes the purchase it inserts an additional $9000 into the economy. But remember that $10,000 was originally supposed to move from B to A over five years. Now the $10,000 will flow from B to the Fed rather than to A. In other words, the Fed has poured $9000 out of its infinite money well into the private sector today, but over the next five years B will pour $10,000 back down into that infinite money well. That amounts to a net removal of $1000 from the private sector. All the Fed has done with its bond purchase is swap out one financial asset- a bond – for a different asset – some money. It has adjusted the schedule of insertions and removals of money from the private sector without effecting a net increase in the amount of money inserted.
Finally, before moving on to a discussion of making the US monetary system more democratic, it will be worthwhile saying a few words about how the current European monetary system falls short of the kind of monetary sovereignty – or near monetary sovereignty – I have attributed to the system in the United States.
European governments are all part of a currency union – the Eurosystem. Each government issues its own bonds and each operates its own central bank. All of these transactions occur in Euros,the common currency of the Eurosystem. But those national central banks are subject to rigorous policy constraints set by the European Central Bank. The individual countries themselves do not set their own monetary policies, and they borrow in a currency they do not themselves control. In effect this makes each government acurrency user rather than a monetary sovereign. If we think of government bonds as the equivalent of bank savings accounts, then each of the governments is in effect the equivalent of a savings bank that competes with the other governments in the Eurosystem to offer attractive interest rates to savers. This gives holders of Euros tremendous bargaining power to drive up bond yields and interest on government debt, because they can always take their money elsewhere to other governments if they don’t get the yields they want. And since the individual governments do not control their own monetary policies, they cannot maintain spending during periods of low revenues by selling debt directly to their national central bank and drawing on the money-creating power of that national central bank. Only the European Central Bank can alter those monetary policies, but the ECB is prohibited by treatyfrom buying government debt directly. The ECB also lacks the capacity to carry out a fiscal policy of central bank financed spending operations in Europe.
In effect, then, the technocratically-managed ECB runs Europe’s private banking system and the private banking system runs Europe’s governments. The citizens of Europe have turned their capacity for economic self-determination over to an undemocratic, continent-wide banking conglomerate. This is the worst kind of nightmare in the long struggle between democracy and private wealth. It’s not as though the Europeans have surrendered their sovereignty to be part of a larger sovereign democratic government encompassing all of Europe. Rather, sovereign democratic governments have been transformed in this instance into something like mere business enterprises that are dependent on private wealth and financing for their operations. These governments now govern only at the pleasure of bankers.
This is Part Three of a six-part series. Part One is here Part Two is here and Part Three is here.
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