In the preface to the forthcoming Festschrift to Alain Parguez, Mosler argues that in the mid 1990s he thought, “the theory of the monetary circuit was correct to the point of being entirely beyond dispute”. However, he also argues that the theory “could be further enhanced by starting from the beginning”. This beginning for Mosler was of course why the workers accepted the units of a currency as payment for their labor services. His answer (which is quite well known among heterodox economists by now) was that imposed debts denominated in that unit of account, give it’s units value; in other words taxes.
This is an important part of the story, but we would argue it is in fact not the beginning. The true beginning to the circuit is the question of where people and organizations gain the ability to tax.
In order to impose liabilities onto a population (i.e., build a tax system), an organization or group needs to have the resources to impose a tax, collect a tax, and use the real resources it gains through spending to expand and institutionalize its power. The catch-22 is that all of these tasks take real resources and personnel, which is precisely what the tax system is supposed to get.
This brings us to history and why this approach has fruitful insights for understanding growth and development. Western Europe was in many ways set up for the modern period by having a deeply institutionalized system of taxation and tribute (some of it in tally sticks and some of it in real resources) before capitalism started developing. They already had the ability and authority to extract real resources and thus it took minimal institutional change to do this purely through a monetary system run by a nation state rather then city-states and feudal hierarchies.
In contrast, elsewhere, such as Latin America, there were traditional systems of authority destroyed or at least greatly damaged by colonial struggle. During the periods in which they were colonies there were colonial authorities that were extracting real resources through tax systems, but they had little to no legitimacy and had little to no interest in deploying that system for domestic development, unlike in Western Europe.
The process of getting rid of the colonial powers itself has importance for development because the revolutionaries have great amounts of leeway for determining the tax system and development strategy for their new government. They are the only ones with the resources and authority to impose taxes, even though sometimes they don’t have enough to start building a state. They also encounter the problem of legitimacy, which is what makes the domestic population more willing to accept the imposition of taxes. They have little to no historical or institutionalized authority to draw from.
In this regard the United States’ uniqueness comes from the fact that the revolutionaries there were largely European colonists and descendents of European colonists who were able to derive authority from their prominent position in colonial governments. Much of the population they ruled over more or less believed in the legitimacy of government and the revolutionaries already had the organizational capacity to tax and use the real resources they get through spending. They also had a lot of experience with this system and knew how to wield it to their advantage, which they saw as domestic development and gaining the loyalty of financiers (who just happened to be their friends) through a massive yet stable public debt.
In a situation where there are other developed nations with institutionalized systems, one way to build a state is to borrow money from abroad and import the resources you need or purchase them domestically from people who know they can import real goods and services. This however, brings us to the problem of original sin. Once they start borrowing foreign denominated currency, then they have to both build a state and build up enough industry to net export and thus achieve a balanced balance of payments. This is very difficult to do and in many cases hasn’t happened.
Thus many developing nations get mired in balance of payment crises before they even have a chance to develop. In turn, their need to accumulate foreign currencies (what is now often referred to as dollarization) loosens the balance of payments constraints of the countries they owe money to.
Three instances of financial development
This paper seeks to propose that the balance of payments constraint should be understood as a historical process and that it is a quite useful tool for historical analysis. What a historical balance of payments analysis requires is an understanding of the domestic and international financial development of countries, which in turn depends on their institutional capacity as outlined above.
Indeed, a (relatively) recent trend among historians has been to argue that the dominance of states historically had much more to do with the role of their financial sector, fiscal powers, and the empire building these allowed. In these histories, the transition to the “tax state,” or the “fiscal state” as opposed to the “domain state” or the “tribute” state is a defining moment. Thus the strength of the state (and in particular its fiscal organization) is associated with development, as opposed to the “light” state described by the “New Institutionalist” authors.
The rise of the public debt that allowed the state to finance nation building was thus associated not with equality of property and democratic reform but with the alignment of financial elites and state governments. In what follows we offer a short outline of the experience of three states during the 19th century to suggest the path which this line of research will take.
For much of the 19th century, the British were able to settle their balance of payments deficits in sterling. That is, short-term inflows allowed a permanent deficit on goods, and long-term outflows.
Short-term inflows were the result of peripheral countries that desired short-term British assets rather than accumulating gold. In addition, non-factor services, investment income, and trade within the empire (particularly India) all played a role in balancing Britain’s external accounts.
British financial dominance was ensured by the building of fiscal, bureaucratic, and military capacity. Indeed, the Glorious Revolution is now seen by many historians as an essentially financial revolution for its new tax structure, the creation of the Bank of England to manage public debt, and the growth of the London stock market. This financial revolution was a prerequisite for the industrial revolution, in part because it ensured that industrial growth could be financed sustainably.
The next major event we should mention is the expansion of British debt during the Napoleonic Wars (to around 250% of GDP). This led to a growth in the size of financial markets, so that not only were consols widely traded, but other private bonds and equities also found a larger number of buyers. In addition, it is in this key period that the Rothschilds, flush from earnings on Napoleonic war consols, began to impose a requirement that foreign borrowers borrow in sterling and make interest payments in London (Ferguson, 2008). Thus the Rothschilds were the first to demand sovereign debt be denominated in foreign currency – and they were able to do this as a direct result of the depth of London’s financial markets, which in turn resulted from the British fiscal state.
Great Britain was not only to issue external debt in pounds, but to demand that others do so as well. This lead to an asymmetric BOP experience for the British as compared to others. The role of sterling in international finance led to a stylized cycle between England and peripheral nations. Long waves of increasing external debt and subsequent default among peripheral countries began in the 1820s and continued throughout the 19th century. In each wave, the British were the primary lenders (Suter, 1992).
While the United States initially issued debt in foreign currency (mostly to other nations), it was not long after the constitutional convention that the U.S. issued external debt in domestic currency. However, there were implicit gold and silver clauses in most of U.S. debt as a result of legal tender laws. Specie clauses were made explicit on US debt after the Civil War, and then finally repealed in 1933(Bordo, Meissner, and Redish, 2002).
The development of a national currency and the initial success in placing domestic currency denominated debt in foreign markets was the result of a build up of fiscal and bureaucratic capacity in the U.S.
In U.S. tax history over the 19th century, the structure and size of taxation can readily be split into two periods on either side of the Civil War. Prior to the Civil War customs taxes were the primary source of revenue, while after the Civil War revenue was drawn from internal taxes. In addition, the Civil War generally marks a turning point in the ability of the Federal Government to wrest control over currency from the states (see Sylla, 1999 on the role of the federal government in the development of US finance). Though the well-known establishment of fiscal capacity by Hamilton (through establishment of federal taxation and the First Bank of the US) ended foreign-denominated debt, it was not until the Civil War that a true movement toward a national currency was established.
The experience of much of Latin America stands in contrast to the U.S. in at least three respects. First, foreign debts that financed revolutions were privately made and not publicly made. As mentioned earlier, the Latin American sovereign debt boom in the 1820s was the first of its kind. In addition, there was a relative lack of fiscal and bureaucratic capacity developed over the 19th century, despite the impetus of war which had proved so important for the U.S. and Western Europe before it (on this point see Centeno, 1997). And finally, there was no strong movement to develop truly national currencies. Indeed central or national banking arrived late and often at the behest of foreign governments.
A key difference determining the different experience of Latin American countries as opposed to the U.S. was colonial heritage. The extractive structures established during the colonial experience in Latin America and the disruption of independence lead to a process of political and fiscal fragmentation.
Instead of turning inward to finance the war, the new and fragmented states turned outward to private financiers. Indeed, turning inward would have been difficult because of the inability of the central state to establish sovereignty and gain the support of domestic elites, not to mention a lack of already existing administrative mechanisms to ensure the enforcement of taxes. A final difference was the nature of each region’s entry into world trade. The progressive importance of the U.S. in international trade made foreign actors more readily willing to accept U.S. debt.
In both the U.S. and in Great Britain, substantial tax and administrative capacity was built up, with a military event then increasing the fiscal state by orders of magnitude. It was after these wars, in which a large amount of public debt had been issued, that both began to solidify their place in international finance.
In many Latin American countries, without a prior buildup of fiscal and political capacity, wars simply lead to further fragmentation. Thus, though it is true that taxes often drive the acceptability of domestic currency, the process of establishing a system of taxation requires an enormous amount of political will and is a process that can easily be interrupted.
Political balance of payments constraint
Among certain portions of Post-Keynesianism, there is much focus on the balance of payments constraint. While we don’t disagree with the idea that there is a balance of payments constraint, we do feel that too often Post-Keynesians are willing to take it’s existence for granted to the point of arguing that balance of payment deficits will adjust automatically. When pushed, these writers will acknowledge other factors, but those “other factors” are at best not a focus.
We take the opposite approach. For us the construction of balance of payment constraints for some countries and their loosening to the point of elimination for others, is a deeply political process. A classic (although under-read and under-cited) example comes from Michael Hudson’s 1970 book “A financial payments-flow analysis of U.S. international transactions”:
“Analysis can highlight the adjustment process, which if it is to work on the cause of today’s balance-of-payments disequilibrium, must work not so much “through the marketplace” as through self-controlling policies by the governments of the “key currency” deficit countries. Otherwise, disequilibrium must continue to be financed through compensating diplomatic arrangements (for example, troop offset-cost agreements such as have been drawn up with Germany), swap lending, and a reconstructing of the IMF to increase U.S. credit lines. Balance-of-payments evolution in this event becomes a function of international power politics.”
From this perspective the ability of a country to run persistent balance of payment deficits depends on how they finance those deficits and whether that financing can potentially go on indefinitely.
The running down of foreign currency reserves clearly can’t go on indefinitely while borrowing in a foreign denominated currency usually can’t either. (That is, unless one has a peculiar situation in which an unimpeachable lender rolls over one’s debts indefinitely. This of course is rare enough to be ignored here.) In our modern world, however, the United States has found a way. It pays in American dollars.
This system relies on the willingness of foreigners (particularly foreign central banks) to accept dollars. This decision is ultimately political. For us the important questions to ask is why other countries are willing to hold foreign currencies and what affects this decision? This brings us somewhat away from the analysis of import propensities and growth rates towards fundamental questions of international systems of politics and power.
Abrams, Philip. “Notes on the Difficulty of Studying the State (1977).” Journal of historical sociology 1.1 (1988): 58-89.
Bordo, M.D., Meissner, C.M., and A. Redish (2002). “How ‘Original Sin’ was Overcome: The Evolution of External Debt Denominated in Domestic Currencies in the United States and the British Dominions.” NBER Working Paper No. 9841.
Centeno, M. A. (1997). Blood and debt: War and taxation in nineteenth century Latin America. American Journal of Sociology, 102(6), 1565-1605.
Ferguson, N. (2008). The ascent of money: A financial history of the world.
London, UK: Penguin Press.
Hudson, Michael. A financial payments-flow analysis of US international transactions, 1960-1968. No. 61-63. New York University, Graduate School of Business Administration, Institute of Finance, 1970.
Suter, C. (1992). Debt cycles in the world-economy. Boulder, CO: Westview
Sylla, R. (1999). Shaping the US financial system, 1690-1913: The dominant
role of public finance. In R. Sylla, R. Tilly, & G. Casares (Eds.), The state, the financial system, and economic modernization (pp. 249–270). Cambridge, UK: Cambridge University Press.