Frances Coppola: Rethinking Government Debt and Monetary Sovereignity

Yves here. This post does a fine job of describing what it takes to be a monetary sovereign, which serves to demonstrate why so few governments qualify. But I do differ with her close, and concur with Marshall Auerback, who said via e-mail:

It’s all good, but the line about “tipping point” is a bit of a cop-out. Clearly, the initial tipping point is when you get to a stage where you reach real resource constraints and keep spending, thereby causing inflation.

The longer term tipping point comes when the government loses its ability to tax, thereby rendering the IOU (which is in effect what a fiat currency is) worthless, as it is the power to tax that gives value to the fiat currency. And that’s more of a political issue, than an economic one.

Bear in mind that Modern Monetary Theory has always stressed that government spending is constrained by inflation, as in real resources.

By Frances Coppola. Originally published at Coppola Comment

There is a huge amount of hysteria about government debt and deficits, not just in the UK but throughout much of the world. As I write, Brazil has been downgraded by Standard & Poors because of concerns about rising government debt and weakening commitment to primary fiscal surpluses in a context of political uncertainty and deepening recession. It is the latest in a long line of downgrades and investor flight over the last few years. The global economy is a very stormy place.

The UK, which has halved its fiscal deficit in relation to gdp in the last five years, is embarking on another round of fiscal tightening, with the aim not only of completely eliminating the deficit but running an absolute surplus by 2020 in order to, in the words of the Chancellor, “bear down on debt”. The Chancellor’s plan enjoys considerable popular support due to a widespread belief that if we do not eliminate the deficit and start paying down debt, we will end up like Greece. “Dealing with the deficit” has become synonymous with good economic management.

But others argue that further austerity to eliminate the deficit and pay down debt is unnecessary and harmful, especially if it means further cuts to investment spending. A growing number of voices call for the UK to increase investment spending even if it means a rise in headline debt/gdp in the short term, because improved growth from the extra investment would result in debt/gdp falling in the longer term. For many of these people (and I admit I am one), deficit phobia is economically illiterate and failing to invest when interest rates are on the floor is irresponsible management of the economy.

Still others say that government debt is unnecessary: a monetarily sovereign government can fund spending through central bank money creation. Jeremy Corbyn’s People’s QE gives a nod in this direction.

So who is right? How much debt should the UK have? What is the purpose of government debt?

To discuss the purpose of government debt, we must first consider the relationship between debt and money. Ever since the abandonment of the gold standard in 1971, governments have issued their own currencies. A government bond issued by a currency-issuing sovereign is simply a promise to issue an agreed amount of sovereign money at defined points in the future. The only new money issued is the interest: the principal payment at maturity simply re-issues the money withdrawn from circulation when the bond is sold. Thus, buying a government bond is exactly the same as placing money in a government-insured time deposit account in a bank. We should really regard government bonds as certificates of deposit. They are simply money, in another form.

Debt issued by a monetarily sovereign government in its own currency is the safest of safe assets. A monetarily sovereign government cannot be forced into default on debt issued in its own currency, and it does not have to tolerate inflation either. Default is a political decision. So is inflation.

But the power to issue money does not of itself confer monetary sovereignty. Many governments that are not monetarily sovereign issue money. What then do we mean by “monetary sovereignty”?

Monetary sovereignty means that the government  has full control over both the amount and the value of money in circulation, in all its forms (including government debt). Note that fixing a value is not the same as controlling it. We generally say that a government is monetarily sovereign if the following are true:

  • it issues its own currency
  • it has a freely-floating exchange rate
  • it has an open capital account

But this would also be monetary sovereignty:

  • it issues its own currency
  • it has a fixed exchange rate or the currency is not traded
  • it has strict capital controls

Note that the definition of “monetarily sovereign” would include some failed states. Monetary sovereignty is not a guarantee of responsible economic management. Sovereign governments can trash their economies if they choose.

There are five principal ways in which governments can lose or relinquish sovereignty.

1. Any country in which the currency used to settle debts ((legal tender) and pay taxes is not issued by the government is not monetarily sovereign. So, for example:

  • Ecuador (uses US$)
  • Panama (ditto)
  • Kosovo (uses Euro)
  • San Marino (ditto)
  • Zimbabwe (anything goes except the Zimbabwean dollar)

This category also includes all Eurozone eountries except Germany.

2. Any country which fixes the value of its currency in relation to one or more other currencies does not have monetary sovereignty UNLESS it also has strict capital controls. So, for example:

  • Bulgaria (currency board to Euro)
  • China (floating peg to a basket of currencies: leaky capital controls)
  • Denmark (ERM II peg to Euro)

Switzerland regained monetary sovereignty when it released its Euro peg earlier this year,  to the consternation of the financial markets.

3. Any country whose currency’s value is explicitly or implicitly determined by the value of a commodity does not have monetary sovereignty.

The most obvious example of this is the inter-war gold standard, whose inflexibility prevented countries such as the US from reflating their economies and thus turned a recession into a Depression. But oil exporters such as  Russia and Kazakhstan also fall into this category. They have now floated their currencies, but their currencies track the oil price.

4. Any country that borrows mainly in another currency does not have monetary sovereignty even if it issues its own currency. This includes high levels of foreign-denominated external debt arising from a large trade deficit. Most hyperinflations involve countries which issue their own currencies but have very high external debt: this was certainly true of the archetypal hyperinflation, that of the Weimar republic.

5. Any country which is largely dependent on trade links to a more dominant country does not have monetary sovereignty. This is perhaps the least obvious category, but it is crucially important. The small economies of South East Asia are dependent on trade ties with China. As the external value of a currency is largely determined by trade, their currencies therefore fall or rise with the yuan even without explicit pegs.

The five categories listed above cover the majority of countries in the world, including some of the largest economies. Monetary sovereignty is a very rare breed indeed. The vast majority of governments cannot issue either money or debt without limit. For most of the world, deficits (including external ones) and debt DO matter. Though perhaps fiscal rules don’t have to be quite as strict as those imposed in the ridiculously-named EU “Stability and Growth Pact“, which are slowly squeezing all growth out of the Eurozone and creating social and political instability.

But there seems to be a select group of countries which do have monetary sovereignty. The most prominent of these is the US, but it also includes Japan, Germany (because it is the Eurozone hegemon and the Euro is really a renamed Deutschmark), Switzerland (now), the UK, Canada and possibly Australia. Oddly, all of these violate one or more of the categories above – but they are nonetheless trusted by investors. Why this is, is a mystery. The key criteria appear to be the following:

  • a history of sound economic management and few defaults (ok, so why is Germany in the list?)
  • a dominant economic position (ok, so why isn’t China in the list?)
  • a credible independent central bank
  • reserve currency status
  • long-dated government debt stocks mainly owned by own citizens
  • stable government and low political risk

These countries enjoy privileges that other countries do not. Although they have very low interest rates on government debt, they do not need to fund government spending with debt: they can simply issue money to meet commitments, relying on taxation and monetary policy to maintain purchasing power. They even have unlimited access to each other’s currencies through central bank swap lines, thus in effect eliminating their external debt liabilities. But these extraordinary privileges do not mean that their own-currency debt has no purpose. On the contrary, they make it more vital than ever – and there is not enough of it.

The debt of this “Premier League” countries has four main uses in the modern global economy:

  • A safe savings vehicle for  their own citizens (particularly vital in those that have poor demographics, such as Japan)
  • A safe haven for foreign investors fleeing from trouble elsewhere
  • An anchor for investment portfolios
  • An essential lubricant in financial markets

Strictly speaking, only the first of these is “necessary” as far as those governments are concerned. Their primary responsibility is to their own citizens. Enabling those citizens to save safely AND invest productively is a part of that responsibility. For that reason alone, these governments should issue enough debt to meet the saving propensity of the domestic private sector, though they might choose to lean against the pro-cyclicality of saving preferences by issuing money instead of debt in recessions and debt instead of money in booms.

But the other three are also essential, from a global economy perspective. The financial system needs safe assets. The fallout when private sector “safe assets” are exposed as the risky assets they really are is terrible. So too is the fallout when sovereign debt issued by governments that do not have monetary sovereignty is exposed as the risky asset it really is. We have seen both in recent years: the 2008 crisis was a failure of private sector safe assets, and the Eurozone crisis was a failure of government safe assets. We are still paying for the consequences of these failures. To pretend that the financial system can manage without safe assets is folly.

This explains the clampdown on government debt and deficits in “Premier League” countries. There is a terrible fear among financial sector actors that these countries will pursue reckless economic policies that destroy the purchasing power of their currencies and the value of their government debt. This fear has been deliberately communicated to the general public in those countries by captive politicians and media, in order to ensure wide acceptance of the austerity policies that much of the financial sector believes is necessary to maintain the value of safe assets. It is perhaps understandable, but it is economically unjustified. The truth is this:

  • Running a primary fiscal surplus in a recession makes the recession worse, raising debt/gdp and increasing the risk of sovereign default
  • Running a primary fiscal surplus when growth is poor and the private sector highly indebted is likely to cause a recession
  • Running a sustained absolute surplus robs the private sector of its savings
  • Paying off government debt deprives the private sector of a safe store of value
  • Increased growth and prosperity arising from productive investment outweighs the cost to future generations

Sadly such basic economics is lost on credit ratings agencies and investors, who see only rising deficit and debt/gdp and start to panic about getting their money back.

It is indeed necessary that the government debt of the world’s “premier” countries should remain “safe”. But draining their economies by forcing austerity policies upon them is not the way to keep it safe. On the contrary, it is likely to make it LESS safe. Safety is ensured through investment in the physical and human capital of the country to secure growth and prosperity for the future.

Clearly, even governments of “Premier League” countries can’t do entirely as they please. There is bound to be a tipping point at which trust is lost and the country is relegated to the second division. We don’t know exactly what that tipping point is. But the message from today’s low interest rates is that we are nowhere near that point. For the sake of both their own citizens and the global economy, these countries can, and should, invest.

Related reading:

When governments become banks
On the new purpose of government debt – FT Alphaville
Government debt isn’t what you think it is

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  1. Moneta

    After the credit crisis, it is quite logical to think that some restraint was needed and austerity made sense. Why would nations want to keep on engaging in the same activities that led to the crisis? A sort of time out was needed to re-evaluate what happened and where we need to go.

    The problem is that assessment has not been made. Our leaders seem incapable of separating the good investments from the misallocation of capital. Therefore, all their austerity measures are not leading to better deployment of capital but to even more misallocation. They are now cutting through bone and muscle.

    They are cutting expenditures that increase velocity of money (less energy intensive or materialistic) and promote activities that lead to even more concentration of wealth (more energy intensive or materialistic).

  2. TomDority

    The key in all this is productive investment. We have today in the USA an investment ideology that fails to recognize non-productive investment…. investment that does nothing but inflate asset prices and skims that asset price inflation into private hands who then recycle it back into further asset price inflation. The real estate bubble as prime example, where the only thing that became more expensive was the land (real estate) values that forced most people to give up more income to service debt to put a roof over our heads. This resultant debt overhead, (the vig paid to the rentier class) used to be called overhead and was not considered as contributing to GDP, ..this upside down thinking is what we call economics today where servicing of debt overhead is considered a contribution to GDP, yet this increase in asset prices required no investment in new equipment or labor to actually produce a product that others would buy….it is unearned income. Sadly, investments in infrastructure, research and development, health care, sustaining the ability of the earth to support life and, that lower the cost of living and working for most people, has been abandoned in favor of the rent seeking unearned increment favored by taxation and economic thought that is so radical that it’s natural course plunges the majority of people into debt peonage and, threatens the existence of biodiversity to the point of jeopardizing the habitability of this planet by humans. Classic economic thought and accounting must again emerge to tax the rise of asset prices and that revenue system must reinvest that increment back into the commons – (our incredible space ship planet earth) – Sorry about the meandering.

  3. Benedict@Large

    These definitions allow to much judgment o enter in to whether a country is monetarily sovereign. The idea that a country isn’t because a major export can swing its currency? So what? What’s the cutoff point. Small countries around a much larger one? What if most of their trade is with that larger currency, so that they have little call for other currencies. And what is a small nation doing worried about currency sovereignty for anyways, Just stay away from the IMF. Again, what are the cutoff points. It all gets so subjective in these definitions and it shouldn’t. This turns this whole thing into a thought enterprise rather than a definitional one.

    And as for a monetarily sovereign country needing to borrow in its own currency? Frankly, it can’t. It’s literally impossible, and Coppella can’t see this because she doesn’t set the transaction up (properly) in its accounting format, which clearly shows that borrowing and printing are identical transactions. (Hint: The proper format requires that the transaction be displayed compete with the initial creation of the money that is eventually “borrowed”. Once this is done, one sees that the borrowing of money by the sovereign in its own currency creates NO NEW LIABILITY beyond the cost of future interest, and a loan without a liability simply isn’t a loan. The liability in fact was created when the currency was created, and not when the “loan” was made.)

    1. washunate

      It’s interesting, I think by the definitions proposed here no government qualifies as monetarily sovereign. How is it even possible theoretically, never mind in practice, to control both the amount and the value of a currency in a remotely open and free society? The former East Germany required the Stasi to enforce the East German Mark’s value. The value was essentially worthless outside of East Germany, and there was basically nothing for sale internally.

      The mechanism that determines the value of the currency is not independent of the quantity.

  4. hemeantwell

    The longer term tipping point comes when the government loses its ability to tax, thereby rendering the IOU (which is in effect what a fiat currency is) worthless, as it is the power to tax that gives value to the fiat currency. And that’s more of a political issue, than an economic one.

    Bear in mind that Modern Monetary Theory has always stressed that government spending is constrained by inflation, as in real resources.

    I think I’m finally starting to get a tenuous handle on MMT. It’s not only a matter of government losing the ability to tax and rendering its IOU worthless. It’s also about losing the ability to tax that allows government to both change the flow of funds within the economy so as to encourage production/growth while controlling inflation.

      1. MLS

        Perhaps it’s worded a bit carelessly and should be phrased more like “lose the ability to enforce taxation”, but regardless, one example would be an economy that has a large underground black market.

      2. hemeantwell

        Re Praedor’s question, I’d recommend you read Streeck’s “Buying Time.” For him, the defining transition in Western capitalism since the 70s has been the erosion of government taxing power in a way that leads to the dominance of financial institutions vis-a-vis governments dependent on borrowing and the “confidence” of financial elties.

        1. Praedor

          OK. Thanks. But then that situation isn’t something that just happened. It was setup to be that way by design. The government wasn’t having issues with funding so that it needed to find some other way to go, it made a (corrupt and corrupting) decision to finance things that way.

    1. Kris Alman

      As I try to comprehend this, I have wondered how a consumption driven economy complicates this. We import cheap goods with “free” trade agreements that outsource more jobs. This keeps prices down and artificially lowers cost of living without sovereign interests truly being addressed. All of this takes a huge toll on the environment when we ship goods that could easily be manufactured here. (Of course service related jobs are also outsourced, compliments of the internet and cheap communication.)

      Are the fires of climate change nature’s wrath for FIRE sectors that are raging out of control?

  5. jgordon

    But others argue that further austerity to eliminate the deficit and pay down debt is unnecessary and harmful, especially if it means further cuts to investment spending.

    What does “investment spending” even mean? If it means setting up sustainable horticulture/food forestry projects–entirely with local resources, and equipping all homes with solar passive thermal water heaters, that’s one thing. If it means expanding and repairing highway systems and funding new petroleum extraction projects then “investment spending” is worse than useless. It’s actively funneling scarce resources into dead-end projects with no future.

    Monetary theories are nice and all, but they look to be useless when the political leaders are corrupt, and worse, when the collective mental framework that society operates on is out of touch with reality. Failing systems almost never manage to reform themselves; they collapse, the bodies are cleared away, and then something new and completely different replaces them. I think we should be focusing on whatever that new and different thing is, in preparation for it, rather than wasting effort trying to reform the dying system.

    1. Praedor

      To be determined. Productive investment in the developed world would be things such as upgrading electrical grids, funding renewable energy (for power production by power companies AND INDIVIDUAL HOMEOWNERS AND COMMUNITIES), upgrading infrastructure (expanding light rail, improving/upgrading/creating high-speed rail, improving, NOT expanding, roads for cars), investing in high speed internet across the country (USPS), funding education (higher and lower), funding basic scientific research and targeted promising research (materials, biological, biomedical, biomechanical), ecosystem repair.

      NOT productive investments: extraction of fossil fuels beyond the barest level actually required for some basic hi-tech industries (you can never really get rid of the need for SOME crude oil because of its use as feedstock for so much high tech and lubrication but you can VIRTUALLY eliminate its use for power production, heating and cooling, and transportation). Any unsustainable extractive activity like mountaintop removal, clear cutting, etc. Personally I think there should be a concerted push to develop OFF-WORLD extraction of minerals – asteroids, the moon.

      1. Moneta

        But even then, when one goes more granular, one can see how difficult it is to determine which productive investment is better than the next… maybe California needs to shrink and investments should grow in other states… maybe many burbs need to contract and smaller cities need to densify, maybe megapolises need to shrink…

        I am 100% sure NONE of these would happen or even be considered if we opened the taps!

    2. Steven

      The ability to produce real wealth – not just the hypothetical income stream from which Wall Street and its banks calculate the ‘value’ of financial assets – is the rock-bottom condition for national monetary sovereignty. The ability to tax is indeed important – but for other reasons than just redeeming the ex nihilo money banks and governments ‘print’ or the ‘near money’ governments create as debt. (See Michael Hudson – “Killing the Host” – on ‘the miracle of compound interest’, ‘big fish eating little fish’, etc or Wikipedia on exponential functions.)

      Probably NO country can be economically – even if it can be monetarily – sovereign, if its people want to enjoy the benefits of modern life, even the United States, e.g. access to China’s natural endowment of rare earth metals. But there are other much more questionable benefits accruing primarily to those with more money on hand than they need at the moment. For such people the ability of money not just to store but to increase its value is critical.

      Wall Street and its banks calculate the value of financial assets on the basis of their income producing potential. In the day to day conduct of business, ‘cheaper’ is far more important than ‘better’ or ‘faster’ as a prescription for making money. Advances in science and technology are arguably methods of cost reduction with which society must ultimately come to terms. But other methods such as the labor and environmental arbitrage of off-shoring or what Hudson calls the New Enclosure movement in which ‘debt peasants’ are denied the means to support themselves and their families by being driven off the land guaranteed them by centuries of feudal tradition or into unemployment lines as the ‘capital’ they used to produce wealth is stripped from their employers and sent abroad in search of higher returns – those methods are, to say the least, much more questionable.

      What is missing in this discussion is “a logical definition of wealth”. Take a look at Frederick Soddy’s “Wealth, Virtual Wealth and Debt”, particularly Chapter VI. It provides a great first shot.

  6. Steven D.

    This article, including Yves’ caveats, is a good cheat sheet of prudent economic policy for sovereign nations. It’s also common sense.

    It provides a strong, easily understood foundation for progressive economic policies, such as those championed by Corbyn and Sanders.

  7. Dan Lynch

    “Any country whose currency’s value is explicitly or implicitly determined by the value of a commodity does not have monetary sovereignty.”

    Agree, but Frances ignores the elephant in the living room –since the 1976 Doha agreement between Kissinger and the Sauds, the dollar has essentially been pegged to oil. Hence the dollar is not truly a floating currency and the US is not truly monetarily sovereign.

    1. Praedor

      And yet, oil prices are down and expected to even go lower but the value of the dollar is higher and potentially about to go higher still. Not much of a peg.

    2. susan the other

      the price of oil pre-1973 was pegged to gold; after that, to the dollar… so since 1973 and thru all the bumpy ride until now, the dollar struggled to be “strong” and also support the entire 3rd World… now not so much and we see our dollar austerity hitting the 3rd World but keeping the core, us, relatively prosperous; like Germany…

  8. Jesse

    ‘Lose its ability to tax’ could also be replaced by ‘lose its ability to impose its valuations.’

    I am recalling my days in the post-Soviet regimes that attempted to enforce the official exchange rates, giving rise to thriving black markets and alternative currencies.

    I am glad to see that MMT recognizes that it is possible for a sovereign currency that hypothecates assets to fail, since so many have. And I think one might even say that given time all have.

    And so what is the pivotal point? The wisdom and restraint of the people who make the decisions about how much to create, and how to deploy it. It comes down to power, and the types and nature of the restraints thereon.

    And so there we are, back once again to the foundations of monetary theory from time immemorial perhaps.

  9. washunate

    The most obvious example of this is the inter-war gold standard, whose inflexibility prevented countries such as the US from reflating their economies and thus turned a recession into a Depression.

    Say what? The depression in the US was caused primarily by unsustainable inequality and its associated gambling-based financialization, the Roaring 20s and all that. The thing about unsustainable things is that they have a way of ending sooner or later. Plus actual, physical, non-monetary challenges, especially the Dust Bowl.

    That is our challenge today. It is distributional in nature, not aggregate. The problem is not a lack of dollars, pounds, yen, and euros. The problem is governments – especially the US – have encouraged the concentration of these currency units into a very few number of hands.

  10. James McFadden

    “1. Any country in which the currency used to settle debts ((legal tender) and pay taxes is not issued by the government is not monetarily sovereign.”

    I guess that means the United States is not monetarily sovereign since our currency is issued by the private banking cartel known as the Federal Reserve. I’m not sure why the author goes on to claim that the US is monetarily sovereign.

  11. Swedish Lex

    Sweden has clearly managed to sqaure the euro circle (unlike Finland and Greece): Full EU Member without any formal exemption regarding the euro (like Denmark and the UK) but still using the Krona with an independent Central Bank.

    Interest rates and fiscal Policy determined by Swedes and not by the ECB and Schäuble, respectively.

    Sweden’s official Policy is to say that “we will join the euro, eventually” :)

    Support for abandoning the Krona and shoot onself in the foot is at a few % of the population.

  12. Penny

    A great deal of very careful thinking is required to identify those investments, funded by governments, which maximize domestic employment (domestic multipliers) without creating bottlenecks, etc viz supply of necessaries. For example, while house-building in the US can be expected to generate mainly domestic multipliers, leakages occur because key inputs (cement, re-bar, etc) are now imported. The same is true for building bridges and other infrastructure projects. Globalization means the devil is entirely in the detail; there is no ‘big picture’.

  13. Knute Rife

    As already noted, “ability to collect taxes” would have been more accurate. A government can lose the power, or will, to collect. It doesn’t have to be the result of stereotypical graft, such as Greece. If the government is still mostly functional, chances are it was through fairly open political processes. For example, look what Congress has done with corporate tax rates over the last 40 years. It has sacrificed the power to meaningfully tax large pieces of the economy at the altar of the neoliberal god KoolAidicus.

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