Sunday, January 11, 2015

How to run a currency Part I: Getting the words right

By now, many of you have grasped (or are at least wrestling with) the key concepts behind how monetary systems actually work in the real world. It’s time to begin rethinking how to use it properly – redefining what responsible fiscal policy looks like for modern sovereign nations.

First, a quick summary.

We've uncovered many of the myths about money that have clouded our vision and that of our political leaders and economic pundits. Our ethical and moral values have been applied in destructive ways to our economy and our national interests because we've misunderstood how the monetary system actually works.

To recount, we now know the following:

We can’t run out of money. 

We now know that sovereign nations can never go broke as long as they i) issue their own currency, ii) have their own central bank to control interest rates, iii) do not borrow money in another currency, or iv) never promise to convert their own currency into something they don’t control (i.e. gold or a larger country’s currency). This is the core distinction between nations that run into financial trouble and those that don’t (setting aside the extreme cases of civil wars, rampant corruption, regime change, etc.) We can’t run out of money but we can use it poorly.

Currencies are a creation of governments, not us. 

We now know that sovereign nations are the monopoly issuer of their own currencies. They create money when they credit bank accounts of businesses and citizens in the economy and they remove it when they tax. Money proceeds first from the government and later returns to it (like any redeemable token), while some gets left in the economy for us to save. Government money doesn't first originate in the private sector to be later taken by the government via taxation. This sequence is the opposite of how most of us were taught and the implications are profound.

Taxes don’t give governments money to spend. 

Since money is created when the government credits bank accounts, the private sector can only get government money AFTER it has first been spent into existence. Hence, taxes are never needed to fund government spending. In fact, it is the opposite: the private sector needs the government to “spend into existence” the money that we must obtain in order to then pay our taxes. Taxes then generally serve the purpose of creating demand in the private sector for the money units that the government chooses to issue so that we will accept those money units when the government pays us for the resources or labor it has been authorized to obtain. This dramatically changes how we think about what and how to tax.  

Bank money isn't like government money. 

Banks can also create new bank money out of thin air when they issue new loans. Bank money is often made to be exchangeable for government money and called by the same name (e.g. Dollars or Yen), but it never adds to the net financial wealth of the private sector because for every bank dollar created there is a corresponding financial debt owed. For every bank-money saver, there is a bank-money debtor. Government money gets added to the economy as a net financial asset for the private sector but bank money never does.

Deficits are really net money injections. 

All money flows are connected in a giant balance sheet for each nation, and it helps to think of this balance sheet divided into three sector balance sheets, all summing to zero: the Government, the Private Sector and the Foreign Sector. What happens in one sector of the economy must, by definition, affect another sector. If imports rise, the private sector (or government) is sending the national currency to the foreign sector (e.g. US Dollars held by China is simply a result of mutual trade decisions). If the government spends more into the economy than it taxes back out, the private sector is gaining money and businesses or individuals gain income. As we will see, this has important implications on how to approach the issue of government fiscal policy.

Sovereign “debt” isn't debt. 

Money that the government creates via crediting business or individual accounts usually ends up sitting in the banking system. Banks, of course, don’t need to keep that money in order to lend it out to new borrowers since we know that they simply create new bank money every time they issue loans. So the money is sent back to the Fed in the form of excess bank “reserves” (banks only keep a little in their vaults for cash withdrawals). This injection of government money that floods the banking system with excess reserves would cause the inter-bank interest rate to collapse to zero. How does the Fed “suck up” the excess? Simply by converting the reserves into interest-earning government bonds, like moving money from a checking account at the Fed to a fixed-term CD at the Fed. The sum total of all these is what we call the government “debt”. Note that there is always exactly enough excess money already in the banking system to buy up every Treasury bond issued since the issuance of Treasury bonds happens after the government first injected new money into the economy and, ergo, the banking system. So this isn't debt in any real sense of the word. An issuer of a currency can never be in debt for the money thing they alone can issue in unlimited quantities. It is simply a means of managing interest rates between banks and also a policy choice to provide interest to bond holders.

A New Money Glossary

Words matter because they are the images that create metaphors and perceptions in our minds. We can see now that we have a very inaccurate glossary of terms when talking about government money. These words and metaphors are a troublesome vestige of the gold standard, and unfortunately, they cause us to think and behave as though we were still under its rule. When we use words like “debt” to describe something that isn't anything like debt, we fool ourselves into thinking we have constraints and problems that are not actually there.

A new glossary of sovereign money can help us appropriately define what it means to be fiscally responsible with government money. We shall see that in doing so, we will upend some bad moral metaphors. Setting the metaphors right-side-up will give us a positive language with which to move forward and inform the public opinion.

National Investment/Net Savings (not national debt)

  • “Debt” implies a burden of earning future income to repay what is owed. This simply doesn't apply to sovereign currency-issuing governments, so let’s stop using the word to describe government bonds.
  • The total accumulation (or stock) of money that has been invested/injected into an economy by the government has a corresponding balance sheet identity as the net financial savings of the non-government sectors.
  • Net investment in the economy (or some may prefer to say net injection of money into the economy) is a much clearer and more positive description of what’s going on.
  • Sovereign governments are never in debt! Let’s stop pretending they are. (In fact, they don’t have to issue it at all but we’d have to solve some other problems before making that shift).

Interest Rate Maintenance (not debt funding)

  • We observe the Treasury issuing bonds and it looks to the public as though the government is going to the money market to borrow so it can fund its spending for the month. It looks as though we are at the mercy of whether banks, funds, and other nations will lend us our national money. In fact, the government has already made its investment/injection of new money into the economy when it turns around to issue bonds.
  • The sale of bonds is used to clear out excess reserves from banks so the Central Bank can hit its interest rate target. It has nothing to do with raising funds. And since the overnight interest rate is established and maintained by the Central Bank, "bond vigilantes" have no mechanism to pressure sovereign governments with rising interest rates. 
  • These interest-bearing accounts at the Fed effectively "vacuum up excess reserves" so the inter-bank interest rate doesn't collapse to zero.
  • Simply put, sovereign governments don’t borrow their own money. Let’s stop saying that they do.

Positive Fiscal Flows (not deficits)

  • When the government invests/injects more money than it taxes, there is a flow of new money into the economy.
  • The word “deficit” is a negative term that implies the government is in a hole and needs to get back out of it. It isn't and it doesn't.
  • The net accounting position after the government is done with its investments, purchases, payments, and taxation is a positive or negative flow of money to the economy.
  • Positive Fiscal Flow is a more accurate way to describe “deficit spending”, and Negative Fiscal Flow is a better way to describe the so-called “surplus”. Note how this reverses (appropriately) the moral framing of the position. Positive flows into the economy are good for the economy; good for capitalism; good for the private sector!

Fiscal Planning (not budgets)

  • We need responsible and efficient government. We don’t want governments that squander resources, waste money, corrupt bureaucracies, or create perverse incentives in government of the private sector. We deserve better government that what we have.
  • We do need a government that functions well and that performs the tasks and makes the investments that we collectively need to progress and prosper as a nation.
  • A process that sets goals for the government, allocates costs, and holds them accountable for the results is appropriate – even essential – for good fiscal responsibility. It doesn't have to be annual but it does need to be regular and required.
  • But it isn't a budget!
  • Budgets are for households and businesses that have to balance their incomes and expenses. Sovereign governments don’t have “incomes” and they create their own money when they need something.
  • Congress should debate and keep a fiscal plan that i) authorizes what the people have requested that the government to do on their behalf, and ii) defines the type and level of taxation that maintains demand for the currency, directs resources in the interests of public purpose, and maintains price stability where possible (given that inflation is significantly a result of commodity supplies/prices, there are limits to what monetary & fiscal policy can do during supply shocks).

Balance the Economy (don’t balance the budget)

  • By now it should be crystal clear that requiring that the government removes all the money that it invested/injected into the economy every year is an incredibly foolish way to operate a national monetary system. Those promoting such approaches to fiscal policy are promoting a highly destructive economic policy that will end quickly and tragically (as it always does).
  • What really matters are the goals set before the nation by the people (e.g. via the Fiscal Plan), and the effect such net flows have on the economy and on real resources.
  • If the economy is growing, people are fully employed and prospering, and resources are being used appropriately and in a sustainable manner, the account balances and metrics economists and politicians love to scare us with (such as debt-to-GDP ratios) are completely irrelevant.
  • We need a balanced, healthy, and sustainable economy, and the flows of government money in and out of the private sector can and should be used to that end, with no thought given to annual budget balances.

Citizen-Authorized (not tax-payer funded)

  • If there was one term we could banish from the policy debates of sovereign nations, it would be “tax-payer funded” (of course, it still applies to all state & local governments since they are users, not issuers, of their currency). 
  • Unfortunately, the clear message behind the term is that all federal government investment/injection of money into the economy first came from some hard working citizen who had their money taxed away by the government. This drives a sense of moral outrage and leads to views that the best government as the smallest government since government can only do something by first taking from the people.
  • Of course, we now know that word-frame is all up-side down.
  • What we should be talking about are the actions, investments, and services we desire our government to perform. What is in the public interest? What can or should the government do that will help the citizenry and private sector and economy? We can then direct our government to issue whatever amount of money is necessary to achieve the goal, after careful consideration to the effects on the economy for doing so.  
  • Fiscal plans should refer to citizen-authorized government monetary and fiscal operations, and end the damaging and erroneous meme of “tax-payer funding”. The decisions on what and how much to tax are completely unrelated.

Investment (not spending)

  • We've implied this throughout, but it warrants repeating for emphasis. Spending is a word that has connotations of using up, exhausting, and maybe even wasting. In fact, when used in reference to government, we often hear of “wasteful spending”, or “spending like a drunken sailor”, or “out-of-control spending”.
  • Very often, the moral outrage driving the use of these phrases stems from the confusion above. I.e. the mistaken belief that the government has too much “debt”, “deficits” are too high, and spending more simply means taking/taxing more.
  • We now know better.
    • We no longer fear accumulations of savings in the economy.
    • We recognize that positive fiscal flows help the economy when it is struggling.
    • We recognize that we can authorize our public representatives to tackle important economic, environmental, national security, and social tasks that benefit the people without burdening them in counterproductive ways through higher taxes.
  • Investing implies taking excess money stock and deploying it in a way that is productive or beneficial, in ways that are economic or social or simply for general well-being. People invest in their education, their health, their pleasure, or their future. Nations can and should do the same, especially investing in their people and capital (i.e. resources that can be used to create more resources).
  • When we have idle resources, human or otherwise, we can authorize our government to invest the necessary amount of money that will employ these idle resources to meet the people's needs and desires and to develop the national capital stock. 
  • And when we have resources that need to be preserved for the common good, such as national parks, city commons, clean water supplies, biological systems, and other natural resources, we can direct our national monetary system to find creative ways to best preserve and sustain our nation’s natural heritage.

So with a correct understanding of our monetary system and a new language to provide the appropriate positive metaphors, we can now apply our moral values to the challenges ahead and find new hope-filled solutions.

  • We can design a responsible fiscal plan that provides for employment to all our citizens.
  • We can design trade arrangements that don’t suppress other nations to benefit our own.
  • We can look at the increased automation of the workforce and smile, knowing we never need to leave our people unemployed, and we can unleash a world of creative possibilities of how to take this gain in productivity and make it benefit all.
  • We can invest in our children’s education, including the education and training of the next generation of workers through advanced degrees and skill development.
  • We can afford to move to a sustainable energy supply through the right investments and incentives, while keeping costs to consumers and businesses down.
  • We can find ways for everyone to access and afford health services, and restore the relationship between physicians and their patients, without burdening businesses with higher taxes and mandates.
  • We can change our tax system to provide the right incentives and disincentives that are in the public, economic, and environmental interest, without ever burdening the poor or stifling innovation and entrepreneurialism.
  • We can look to the future and make wise and bold investments for future generations, building state-of-the-art national transportation infrastructure, communications systems, beautification and art projects, and much more.
  • We can steward the beautiful land we have the privilege of sharing together, and restore and regenerate the ecosystems that our industrialization processes has harmed, while still providing for strong national economic growth and prosperity.

We are only limited by our imaginations, our creativity, our frame of mind, and our real resources. Never by money.

This is the road that leads to hope-filled economics. Jump on board!

Up next, Part II: Taxation for dummies.