By Nathaniel Cline and Nathan Tankus, a student and research assistant at the University of Ottawa. You can follow him on Twitter at @NathanTankus. Cross-posted from INET.
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.
Great piece! More from these authors please.
Doesn’t part of it come down to ethnocentrism through the filter of the perceived stability of institutions? If the local elites in a given colony see themselves as a part of their larger outside power of origin (or perceived origin in the case of second or third generations) they will conduct their business in that currency so as to protect their position in the longer run. They don’t see any common interests with the locals, they only see a chance to exploit them to their benefit. Their interests contribute to the instability of their country of residence. In other words, it seems strange to not discuss racism in this context. Thanks for the thought provoking essay.
Thanks for your kind words!
Your comment is logical but doesn’t fit with the facts. There are many cases of colonists or people who see themselves as colonists using the domestic currency for various reasons (usually because they have some kind of debt in the domestic currency). Your logic however almost certainly applies to the balance of payment constraints post-colonial governments have. In other words a believe that that group can’t manage its own affairs reduces the likelihood foreign actors will hold their financial assets without a guarantee like a foreign currency peg or debt drawn up under British law paid in sterling. Or the more recent term “dollarization”.
The growth of Industrial England began much earlier although was on a smaller scale. (using only coal for heating and water for machines)
Industry & cities need a surplus goods hinterland.
NORMAN TRADE BETWEEN DINGLE AND THE CONTINENT
When the Normans settled in Dingle, the harbour began to evolve as a major trading point in the South West of Ireland. The principal exports from the town were wool, hides, salt meat, fish and butter. The chief imports were wine, salt, coal and articles of clothing. An Act of Parliament was passed in 1569 which limited the number of ports through which wines could be imported. Dingle was listed among the towns in this Act and is referred to as “Dingle Husey otherwise called Dingle I Couch”
SPANISH INFLUENCE IN DINGLE
Dingle reached the highest point of its importance in the course of the sixteenth century. It was one of the great trading ports of the south. Continental wine ships and other merchant vessels plied in and out of the harbour, tying up at the Spanish pier, (presently Dingle Marina). Dingle was the main embarkation port for the great pilgrimage to the shrine of St. James at Compostella in Spain.
Strong commercial links developed between Dingle and Spain throughout the sixteenth century. Several of the Houses in Dingle were built in the Spanish fashion, with ranges of stone balconies and marble door and window frames. Inserted in the walls of houses in Green Street are stones with curious carvings which are still well preserved. One of these has the date 1586 prominent on it. The others are more ornate and depict birds. It is believed that these stones are survivals from a bygone age and the houses of the Spanish merchants who settled in Dingle at that time.
The parish church of St. James is said to have been built by the Spaniards around the time of the great medieval pilgrimage to the shrine of St. James of Compostella, and was dedicated to St. James the patron Saint of Spain. When the Reformation reached Dingle in the 16th century, the church passed into Protestant hands.
In 1529 Charles V, King of Spain and Emperor of the Holy Roman Empire, sent his personal envoy, Gonzalo Fernandes to Dingle to parley with the Earl of Desmond. An account of this meeting shows that the Earl wished to forge a political and military alliance with Spain and to have weapons and aid sent over from Spain to help the Earl rebel against England
The Tudor objective was quite clear.
Stop balanced trade.
Extract a net surplus from the colonies. (prevent the Irish from drinking continental wine and indeed burning Scottish coal in the 1500s !)
Use the surplus to industrialize
Where did Lizzy the first get her surplus goods so as to mine copper in the Lake district ?
Ireland of course…..surplus energy( food )came from Ireland.
Ditto for riches from the new World.
If it’s ever written, The Black Book of Shitty Things the English Have Done to Brown Skinned People, Plus the Irish will put The Black Book of Communism to shame.
The English are clever though. The colonial authorities in Kenya interred the whole Kikuyu people in a massive system of rape camps, and to this day “Mau Mau” remains a dark pejorative evocative of black savagery, while “English” equates to civilization itself, evocative of Oxford dons, gentle manners, and Monty Python. Neat trick, that.
Its important to understand that it was the Tudors which really fucked over the Irish.
You see the Tudors were not really sov kings.
A true sov king does not care about inflating banking assets – he has fiat power.
The Tudor kings & queens were dumb.
They wanted to get rich !!!!!!!!!
Yep Nathan you might have to relinquish the moron of the year award and give it instead to somebody like . . . there are so many it’s hard to choose . . . maybe somebody from Princeton’s econmomics department just as a show of respect for imstitutional authority. eventually economics will be seen for what it is, a study in group psychology and the analysis of ego formation, and money will be seen for what it is, a catalyst for individuation from the hive mind through expression of instinct and imagination. until then, we will have to suffer sterile mathematics and still-born analytical frameworks that illuminate nothing and simply confuse.
PLAYING GAMES WITH WEALTH
The second term of Obama shows an average deficit of 500 Billion.
Why cannot we have a progressive tax topped at 50% and start paying down the horrid debt?
It is possible but not as long as the wealthy have control.
They are not willing to sacrifice as was done 1945 to 1980 as we paid down the WWII Debt.
Good paying jobs have gone overseas along with health care insurance and pensions.
Great read. Infrastructure fascinates me in the political aspect of how people over think it. If something is so valuable that it shutting down or being run poorly harms the public, then it should be owned and run directly by the government.
If it is simply for private benefit, then there is no public purpose in subsidizing it.
Now, of course, it is obvious why the corporatists would want to confuse the issue, but I remain constantly flabbergasted by Democrats who go along with the charade.
P.S., apparently some user error here. I thought I was reading and commenting on the post about NYC transit…oops
The analysis by Cline and Tankus raise some fascinating methodological and historical issues.
Cline and Tankus state that “In order to impose liabilities on a population (i.e. build a tax system) an organization or group needs to have the resources to impose a tax, collect the tax, and use the real resources it gains through spending to expand and institutionalize its power. The catch-22 is that all of these taxes take real resources and personnel, which is precisely what the tax system is supposed to get.”
Methodologically it appears that there was an initial decision made by Cline and Tankus to employ a narrow horizon of analysis which focused only on the act of taxation and consequently couldn’t account for the “real resources and personnel” of individuals in the emerging nation-state who carried out this act.
In formulating their-catch 22 Cline and Tankus made an apparent antecedent decision on how to situate their problem–which seems to suggest that the language of problem identification is metaphorical—that it does not transparently reflect a situation that exists independently of ones conceptual formulation.
Then they argue that “They (the nation-state) had the ability and authority to extract real resources and thus it took minimal institutional change to do this through a monetary system run by a national state rather than city-state and feudal hierarchy.
The dissolution of their more narrow catch-22 situation then takes place through another act of conceptual slicing which succeeds in enlarging their horizon of analysis to take into consideration the apparent origins and evolution of the nation-state as the basis for the powers of taxation.
Could it be that any historical analysis (mine or that of Cline and Tankus) should be understood as a normative vision(because of different choices by any set of analysts about conceptual slicing) and not just a purely descriptive one?
Could it be that we never really get back to the beginning because there is never any purely descriptive reading of any situation or event?
Those based in the U.S. Boosted their work forces in 2011 almost entirely by hiring workers overseas, underscoring the slow growth in the U.S. Job market.
The U.S parents of multinationals account for about one -fifth of total private U.S. Employment.
Since 1999, employment by U.S. Multinationals is down by 1.1 million inside the U.S, while it is up by 3.8 Million overseas.
The hiring of American companies is not happening in the U.S. These companies hold $1.7 Trillion of profits away from shareholders and out economy to avoid taxes.
While we don’t disagree with the idea that there is a balance of payments constraint,
Do you agree with MMTers (and many others) who say there isn’t, in a modern financial system? I.e. that the US does not have some intrinsic, structural privilege now that Canada, the UK, Japan, Australia, or even poorer countries etc do not or cannot share? Seems like you do, but not entirely clear.
Oh, and fascinating piece!
To a certain extent. Neo-chartalists would describe my statement that “This system relies on the willingness of foreigners (particularly foreign central banks) to accept dollars.” as
“it’s the foreigners who are dependent on our domestic credit creation process to fund their desire to
save $U.S. financial assets.”
(Mosler, 7DIF pg 62 https://docs.google.com/viewer?url=http%3A%2F%2Fmoslereconomics.com%2Fwp-content%2Fpowerpoints%2F7DIF.pdf)
I wouldn’t say desire to save U.S. financial assets because in many cases no foreign agent “wants” to accumulate U.S. financial assets before hand. It is more accurate to say they are willing to in certain circumstances for many different reasons (many of them political).
Using the language Neo-Chartalists employ, what i describe here as a balance of payments constraint would be understood as little or no desire from foreigners to accumulate domestic financial assets. In this sense, for us a balance of payments constraint doesn’t rely on a fixed or floating regime. Indeed I would say Britain for example had little to no balance of payments constraint during the 19th and early 20th century despite being on the gold standard for some of that period. Of course, the nature of the Fx regime certainly has profound effects on these decisions.
To circle back directly to your original question, I wouldn’t say the U.S. is in a completely unique position balance of payments wise. It’s all a matter of degree. There are is probably more willingness to hold U.S. financial assets then financial assets denominated in any other unit of account. But this can’t be measured very well since its ultimately political.
Could you explain why the desire to hold dollars is more of a political choice, say, than, an economic one?
How does the full faith and credit of the dollar relate to political, instead of economic, environments?
Well from my point of view most of the adjustment balance of payments wise has been government (especially central bank)led rather then private sector led (Hudson’s book is quite good on this). In this context, the decisions that have determined these dynamics have been made by political institutions. now sometimes they are made for economic reasons. but I would still call them political decisions. To give a somewhat different example, the stimulus was done for largely economic reasons but the decision to do so was a political one. But even moving on from this, the balance of payments have been more political then economic. a big part of the United States balance of payments deficits have been from fighting wars and running bases in foreign countries (Hudson presents data suggesting that in the 60’s United States balance of payments deficits was equal to the government’s balance of payment deficit). He also spends a lot of time in his book Global Fracture showing all the political negotiations around holding dollars and attempting to form alternative currency blocs (the Euro should be seen in that context).
Thanks for your explanation, Nathan.
I would agree with you that the central bank has seemed to rise in importance as the private sector has struggled.
It seems to me that, while politically, it may be a smart move, economically, we are asking for trouble giving so much influence to the central bank.
I believe the central bank is responsible for much of the private gains in the stock market.
How comforting is that to think of? Will this stimulus have to go on ad infinitum in order for us to not take our licks now, in lieu of a more sustainable economic future for the generations to follow?
OK, so you seem to me to agree with MMTers (& Lerner, and many others). But there are too many people, even, tragically, perhaps especially, ‘Post-Keynesians’ who believe in mystical constraints on domestic “expansion”, a constraint in addition to inflation. A constraint which is not a matter of degree as you say, nor translatable into neochartalist language. (Or any known human one, imho :-) )
But I think you overstate the political nature of an economic decision. The decision would not be politically possible if it were not economically and practically defensible. The economic defense is that entities saving dollars are not being ripped off, and they haven’t been. The foreign willingness is not so different from domestic willingness, for the same qualifications apply.
Indeed I would say Britain for example had little to no balance of payments constraint during the 19th and early 20th century despite being on the gold standard for some of that period. Yes. A more realistic description imho is to say that gold was on the pound standard, and then the dollar standard, not vice versa.
You might say “the system”, the status quo, depends on foreign willingness. But the USA does not. It does not depend at all on such foreign behavior, to the extent that the USA practices functional finance rather than austerity strangling its real economy.
The British had most of the below ground supply (they were good for it under a gold standard)
Just before the Great war both (friendly) France and (hostile) Germany held most of the above ground gold.
London did not hold all that much.
Gold flowed out in return for real goods from France and Germany.
In a sense the modern world is not much different.
Just replace gold for treasuries with China serving the role of Hostile Germany & Japan as France.
Modern Europe is surplus goods India.
This is a fascinating topic, from an historical perspective. I think the only parallel I see is with Rome, or possibly ancient Eqypt. The point is, “why is the U.S. dollar the world’s reserve currency?”‘ despite past inflation, our deindustrialization, massive trade deficits, fiscal deficits (though manageable).
And, like in the past where all roads led through Rome, all on-the-ground military action of any significance (i.e. we care about it) goes through Washington. Economists rarely discuss the raw military violence power of an economic entity—it is too hard to quantify in an equation, and certainly cannot mold itself to fit in a “rational consumer” model for behaviour. And we really don’t know what goes on behind the scenes when the international lobbying/competition to be the world’s reserve currency is carried out, if it even is.
By default, by outspending the entire rest of the planet COMBINED on defense, and on top of that ridiculous fact, we still have more guns in private hands than in the military’s, it is pretty clear who the world’s “cop” or maybe “extortionist” is.
We don’t have much competition arising either–could you imagine China allowing private gun ownership on the scale orf the US? They won’t even allow their own people to access WEBSITES on what our Second Amendment is.
The most interesting part of this, and I remember clearly that both Geithner and DeLong made similar comments along the lines of “what an interesting experiment it would be if we weren’t required to be the world’s common backstop currency?” The thought behind this being that being the world’s reserve currency is actually retarding our growth rather than letting it proceed at a normal rate. On the other hand, being the world’s reserve currency means never having to say “we are bankrupt” so long as we control the printing presses–so maybe it is just a stabilizer rather than a benefit or hindrance. Then again, I would like to know how the British pound did during the peak and decline of the empire–surprisingly little about exchange rates during that period seems to be available