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Fiscal Sustainability Teach-In: Session 2, Stephanie Kelton

1st Fiscal Sustainability Teach-In and Counter-Conference

Session 2

George Washington University, Washington, DC

April 28, 2010

Stephanie Kelton: Are There Spending Constraints on Governments Sovereign in Their Currency?

Stephanie Kelton, Associate Professor of Macroeconomics, Finance, and Money and Banking, Senior Scholar at The Center for Full Employment and Price Stability (CFEPS), University of Missouri – Kansas City, Research Associate at The Levy Economics Institute of Bard College, and blogger at New Economics Perspectives

Stephanie Kelton: [00:00:00] Well, I think we have the same crowd we had before, which is very nice to see. We haven’t put anyone off too terribly yet. My name is Stephanie Kelton and I’m very happy to have an opportunity to come and elaborate on some of the things that we’ve started talking about this morning. The title of the talk that I was asked to give is ‘Are there spending constraints on governments sovereign in their own currency’, and Professor Mitchell answered that question in the previous session and everyone was here for that. So, if you’d like to break for lunch… [laughter] Just kidding! [00:00:39]

I’m going to go ahead and say something anyway about this, and what I’m going to say is based on what was described this morning as something called Modern Money Theory. This is not a term that we came up with. I think that others who began to follow our work branded us with this title and started referring to us as the Modern Money School and to our ideas as Modern Money Theory and in many ways I think it’s kind of unfortunate, but this is the brand that we now, or the cross that we now bear, because it is something of a misnomer. What we’re doing is actually not modern at all. The ideas are not theoretical, and they aren’t particularly modern. What we’re doing is simply describing, operationally, the way government finance works. It’s not a theory; we do not make assumptions, although we are economists. What we’ve been describing to you today is not dependent upon any ceteris parabis condition or any set of assumptions about perfect competition or rational agents or anything else that you get exposed to when you study economics, but rather an attempt to simply describe the way in which the institutional arrangements are set up, and the accounting identities and what happens in a balance sheet framework; when one side of the equation moves, what happens on the other side of the equation? That’s really all we’re up to, so don’t be afraid. [00:02:09]

As I said, the ideas aren’t particularly modern. I could have filled the page with names of folks who’ve come before us, espousing exactly the same kinds of things that we’re talking about here today. One of the earliest was a German economist by the name of Georg Friedrich Knapp, who wrote a book called ‘The State Theory of Money’. Many of the same ideas that you’re hearing from us today can be found in the work of Knapp. They can be found in Keynes, most specifically in his ‘Treatise on Money’ published in 1930, and they can most surely be found in the work of Abba Lerner, who wrote extensively on this kind of thing, publishing papers with titles like ‘Money as a Creature of the State’. So, they are neither modern nor are they theoretical, but we like them. [00:02:58]

What we didn’t do, I guess, a lot of this morning is really to talk about money, and what is money. And, while there were some references to accounting, and blips on a screen and button pushing and so forth, we didn’t really distinguish what we’re talking about in Modern Money Theory from what most of the textbooks describe and what our students end up getting taught in most economics programs across the globe. [00:03:27]

When you open up an economics textbook, and you turn to the page that begins to talk about money, inevitably you find a story that begins with something about barter; and ‘once upon a time’ man trucked his wares to the local trading venue because he’s preprogrammed to truck barter in exchange, as Adam Smith told us, and there was no currency around. So you had to lug your clay pots and your shoes and your fish and whatever else you may have specialized in the production of, down to some local trading venue, where the only way the exchange could take place is if you happen to come upon the person who not only had what you wanted, but wanted what you had. [00:04:10]

Economists refer to that as the double coincidence of wants. And so, barter is this clumsy system for conducting exchange and, so the story goes, man suddenly decided – hey there must be a better way to organize – we should really think about finding some Thing that would be universally accepted. And, lo and behold, they hit on money, primitive forms of money first. The textbooks tell stories of things like pebbles and shells and feathers and beads and all of that, and later discovering money things like precious metals, which had nice properties that fish and other commodity monies didn’t have, in that they would serve as a good store of value, they were easily divisible, they were portable – you put your coins in your pocket and go conduct your exchange. [00:04:58]

But, the story is always told that this somehow happened spontaneously. The private sector figures out that there’s a more efficient way to conduct exchange. They choose to use money. They decide what money is. And this all happens without imposition from any authority, no state, nothing like that. So the money is stateless. And, then of course, over time, money evolves (I’m still in the textbook story) from things like primitive money to gold and then to paper with gold backing. People take paper in exchange for real goods and services and the argument is – well, but at the end of the day, it’s as good as gold. So they continue to accept the paper. [00:05:42]

Then the story gets more difficult to explain, for this group. Sometimes we call them the Metalists because, when you have a pure fiat money system, why do people accept currency, that is intrinsically worthless, backed by nothing of value, and yet people will beg, borrow, steal, toil away the day, in order to get these otherwise worthless pieces of paper? [00:06:05]

And so, what we like, what we prefer, is the story that’s been dubbed, or the approach that’s been dubbed Modern Money Theory, which traces the nature and origin of money to the early authorities. Randy has written a lot about this in his, ‘Understanding Modern Money’ book, from the early temples and later to the nation states and we could go on and on about this, but that’s not what I want to do. But, it does trace the origin and nature of money to some power authority; that is, the money does not emerge spontaneously by the will of the people, but it is imposed on them. [00:06:43]

How is it imposed on them? It is dictated by the authority. It is chosen. The authority establishes that you all must pay something to me. I define the unit of account. In the United States, the unit of account is the dollar. So I say in what unit you must pay obligations to me and then I tell you what you have to do to eliminate those debts. And so, I impose a tax liability on you. I make you indebted to me. Now you need to do something to eliminate your obligation to me. And I tell you how you can do that. In the United States, you can earn dollars. You pay your tax obligation to the state in U.S. dollars. That gives value to the government’s otherwise worthless pieces of paper, and allows them to move real resources from the private to the public domain. [00:07:34]

So we have a very clear way to answer the question ‘Why is fiat money accepted?’, whereas our textbook counterparts have some difficulty with that. If you push them too hard, they say, ‘Well, Pavlina accepts dollars from me when I go into her shop because she knows that she can pay Warren her rent with those dollars’. And then you say, ’Well, why does Warren take them?’ ‘Well, Warren knows that he can pay Marshall when he rents a car from him’. ‘Well, why does Marshall take them?’ ‘Well, Marshall knows that Randy will take them.’ And you get into this infinite regress problem. They really have no answer, is the problem in that theory. [00:08:08]

So the Modern Money approach accepts that the currency derives its value from the state’s willingness to accept it in payment to the state, to eliminate obligations to the state. Now there are lots of things that obviously circulate as money things. The government’s money is not the only thing out there. And there is some ordering, or hierarchy of money things. Some are more generally accepted than others. [00:08:39]

And so here I have a quote from James Tobin just to give this some credibility because we pull out the Nobel Prize winner when we want to convince you that these ideas are not crazy and fringe, and James Tobin said in a book in 1998, “In advanced societies the central government is in a strong position to make certain assets generally acceptable media by its willingness to accept a designated asset in settlement of taxes and other obligations. The government makes that asset acceptable to any who have such obligations and in turn to them and to others and so on.” [00:09:14]

So Pavlina takes it because she has obligations to the state. If she herself doesn’t, she knows she can find someone who does. That’s why this thing is special and that’s why the government’s IOU is special and those of us that have done some work in this area, in talking about a hierarchy of money would argue that the reason that the state’s IOU, the state’s money sits at the top of the hierarchy is because it is the most generally accepted and it gains its acceptability by virtue of the state’s proclamation that we all need it in order to eliminate our tax liability. [00:09:48]

So, Modern Money Theory stresses the relationship between the government’s ability to make and enforce tax laws on the one hand, and its power to create or destroy money by fiat on the other. I would define as a sovereign government, a government that retains these powers, that they are sovereign in their own currencies. Among others, examples of governments with sovereign currency, the United States, Canada, UK, Japan and Australia, all sovereign in this regard, by this definition. [00:10:21]

So the question then becomes, for a sovereign government, how much can it spend? Can it afford Social Security? Medicare? Tax cuts? Is the current path sustainable? Isn’t inflation going to be a problem? Will we bankrupt our children and grandchildren? What if the foreigners decide they don’t want to hold our bonds? I am only going to answer a couple of those questions in this talk because many of those are designed to be answered by other panelists later today. [00:10:51]

So, here we have the analogy. This is what most students who study economics are taught, and Ross Perot, I think, deserves a lot of credit for the fact that people think in these terms today, or blame, as the case may be. Ross Perot told us early on, just like the government, every American has to live within his means, and President Obama has told us that the government is out of money. So, what is the basis for this household government analogy? The household clearly has a budget constraint. And we also teach that in our economics classes. Micro economics teaches students how to maximize utilities subject to some constraint, face a budget constraint. How much money can you spend? You can spend everything you receive, either working or unearned in some capacity – gifts, interest earnings, whatever it is - after taxes, plus everything you can borrow. That’s what you can spend. And when it comes to buying things in the United States there’s really only one way to make final payment. When you purchase something, at the end of the day, the only way to pay for it is with the government’s money. There is no other way. [00:12:05]

How does that work? And so here’s an example. Suppose that you go out to dinner and you purchase your meal with your Visa card. Is that the final payment? No. You get a bill in the mail from Visa, and what do you do? You write them a check. Is that the final payment? Well, maybe the last time you see anything happen, but it’s not the final payment. At the end of the day, Visa doesn’t want your check. It doesn’t want what you’ve written down. What it wants is a credit to its bank account and that happens as that check goes through a clearing process and Visa’s bank account is credited with reserves. What are bank reserves? Government IOUs. Federal Reserve money. government money. Only the government’s money can discharge a payment as final means of payment. We are the users of the government’s currency. [00:12:59]

In contrast, the government is the issuer of its currency. It is not like a household. It doesn’t have to raise money by borrowing or collecting taxes in order to spend. Those of us in the private sector have to earn or borrow dollars before we can spend. The government must spend first. And we say this, and sometimes people have a hard time understanding that. How can the government spend first? How can it not spend first? How could the government collect taxes, in dollars, first? It first had to have spent those dollars into existence. The spending has to come before the payment or the collection of taxes. The government must spend first. Government spending is not (we use this term a lot) operationally constrained by revenues. It doesn’t need tax payments and bond sales in order to fund itself. It is not operationally constrained. The only relevant constraints are self-imposed constraints. We talked a little bit about this earlier, things like debt ceilings. That’s a self-imposed constraint. Rules that prevent the Treasury from running an overdraft in its account at the Fed. That’s a self-imposed constraint. It is a constraint that is imposed by Congress. Rules that prevent the Fed from buying Treasury bonds directly from the Treasury, so-called monetizing the debt, is a self-imposed constraint. [00:14.36]

How does the government actually spend? It spends by writing checks on its account at the Federal Reserve Bank. What we see, and what we hear all the time is that the government is spending a hundred, taxes are ninety and it sells bonds equal to ten. So, what we see is an attempt to coordinate the government’s spending with taxes and bond sales and it creates the illusion that what’s happening is that the government is taking money from us and using it to pay for the things that it purchases. But that’s not really what’s going on. As Warren likes to say, the government neither has nor does not have any money at any point in time. It is simply the scorekeeper. So what happens when the government spends? [00:15:24]

Let’s suppose that the U.S. Treasury issues a check for a hundred million dollars to Halliburton. What happens? The Fed marks down the Treasury’s balance. It subtracts one hundred million from the Treasury’s account at the Fed. Halliburton takes the check and deposits it wherever Halliburton happens to bank. I chose Bank of America. So Bank of America marks up Halliburton’s balance by a hundred million dollars. The Fed marks up the size of Bank of America’s reserve account (this is some reserve accounting, hang in there; it’s a little dry). The Fed, in the clearing process, credits Bank of America with a hundred million dollars in its reserve account. [00:16:08]

So what’s happened at the end of the day? What are the effects of government spending? The monetary base increases. We call that ‘high powered money’. Those are the bank reserves. The monetary base increases by a hundred million. The money supply increases by a hundred million. The money supply is all the checking accounts and traveler’s checks and a couple other things, but by and large, those are the deposits, ordinary everyday checking accounts. So the money supply increases. So what is the lesson from this? The lesson is that government spending creates new money, both high-powered money, bank reserves, and the more narrow definition of money, M1. They both increase as a consequence of government spending. [00:16:50]

How about when the government collects taxes? What happens there? Say you write a check for five thousand dollars to the IRS on your personal checking account, and you bank at Wells Fargo. Wells Fargo marks down the balance in your account, minus five thousand. The check gets sent from the IRS to the Treasury’s bank. The Treasury banks at the Fed. The Fed marks up the Treasury’s balance by five thousand, and the Fed marks down Wells Fargo’s balance by five thousand. What happens at the end of the day? The effects of paying taxes (See, when you pay taxes, there’s nothing there. Everything just disappears.) The monetary base decreases. Bank reserves go down by five thousand, so the base goes down. The money supply also goes down because you drew on your checking account. So, the money supply goes down by five thousand, the narrow measure, M1, and the monetary base goes down as well. Paying taxes destroys money. It doesn’t give the government anything. It doesn’t get anything. It eliminates those liabilities. They are, for all intents and purposes, destroyed. [00:18:06]

That’s if you pay with a check. What would happen if you actually sent the government your cash? Every once it awhile it seems like you hear about some crazy person who does this in protest. They get a huge sack, usually of coins just to make it really offensive and difficult on some poor bean counter. Let’s say you have a tax liability and it’s a hundred dollars and you just mail in a one hundred dollar bill. Apart from the shock of opening the envelope, what are they going to do with this? What do we do with this? Send it to the Fed. That’s where the Treasury banks. Goes to the Fed, and what do they do with it? They shred it. They shred it. Why would they shred it, I mean literally shred it, if they needed it to buy things, if they could use it to spend? Because they don’t use it to spend and they don’t need it to buy things. [00:19:06]

So why bother collecting taxes at all, if the government doesn’t need our money, and this came up earlier. Lynn raised this question. Why bother collecting taxes? When we pay our taxes, whether by cash or by check, all we’re doing at the end of the day, is returning to the government its own liabilities. That’s all we’re doing. And they say, ‘Thank you very much’, and the transaction is done. They don’t get anything that they can turn around and spend. They get their own IOU back from us. That’s the end of the transaction. [00:19:40]

So, why do it? Two reasons. One is, and this goes back to the Modern Money Theory that I began with, one is that taxes give value to the government’s money. If they were just to say, ‘We don’t need taxes in order to spend, so let’s suspend all collection of taxes’, that would undermine the value of the currency. It would take away the need that we have to acquire the government’s money. Why would we work and produce things for the government? Why would the government be able to move resources from the private sector to the public domain if it can’t get us to do that by virtue of the fact that we are willing to work and provide things to get the government’s liabilities? So, taxes maintain a demand for the government’s currency – that’s important – and the other thing they do, is they allow the government to regulate aggregate demand. Too much spending power can be inflationary, too little causes unemployment and recessions. [00:20:42]

All right, well then, why does it sell bonds? What are bond sales all about? It’s not selling bonds to cover a shortfall because it needs to borrow money from us. A lot of people have argued, and Bill talked about this a little bit earlier with the Rogoff-Reinhart piece, that there’s a tipping point out there. Won’t we sell too many bonds? Won’t the debt get too large? Isn’t there some point of no return beyond which the whole system collapses? What if the interest payments become too large? What if the rest of the world decides they don’t want to buy the bonds? [00:21:21]

Bonds are nothing more than a savings account at the Fed. We give up dollars today and we receive dollars plus interest at a future date. So if the government sells bonds today, funds get moved from checking accounts. People who have money buy the bonds. Funds move from the checking account into what’s effectively a savings account. It’s the interest earning asset, IOU of the government. So, that’s what we hold now. When the bonds mature, the government credits our account, principal plus all of the remaining interest, and the funds are converted back into checking accounts; they move from saving back into checking accounts. [00:22:04]

I couldn’t get the twelve trillion. I wanted the actual number, 12.4, wherever we are today, but this is as recent as I could find. This is the national debt clock, the sum total of all of the outstanding bonds that the Treasury has issued. And, what we would argue is we shouldn’t call that the national debt clock; we should just rename it. It’s the national world dollar savings account. All it does is keep a record of the total amount that’s invested in savings as opposed to checking accounts at the Fed. It’s nothing more than that. [00:22:44]

Something about the issue of solvency, the tipping point problem. Can the government run out of money? The U.S. government can’t run out of money any more than the Washington Nationals Baseball team stadium can run out of points. Every time a ball game is played at Washington National Stadium, some team scores some points and they appear on the screen and then the other team scores and some more points appear on the screen. And there’s nobody behind the screen going, ‘Hey Johnny, we’re running out of points here’, you know, right? Look in the trust fund. That’s not the way it happens. You just add the points. [00:23:30]

Same exact thing with the way the government operates. And this is the quote that Marshall brought up earlier and the one that Warren likes to use a lot, and I like it too. So here it is in writing so that you know we didn’t make it up. This is Ben Bernanke in an interview on Sixty Minutes just last year when Pelley asked him, "Is that tax money the Fed is spending?" And Bernanke says, "It’s not tax money. The banks have accounts at the Fed much the way that you do, have an account at a commercial bank. So when we want to lend to a bank, we simply use the computer to mark up the size of the account they have with the Fed." [00:24:00]

It’s exactly like putting points on the screen at the baseball game. Just mark up the balance. Can you run out of points? Can the government run out of money? No. There is no solvency issue when you are the issuer of the currency. OK, this is a quote from Alan Greenspan saying largely the same thing. "A government cannot become insolvent with respect to obligations in its own currency. A fiat money system like the ones we have today can produce such claims without limit." [00:24:34]

My parents told me money didn’t grow on trees. It didn’t for us. Then, why, if this is true, why are the PIIGS in trouble? Why are Portugal and Greece and Ireland and Spain and Italy; why is there all of this talk about them not being able to fund themselves? I mean, they have a fiat currency. [computer glitch] Why are they in trouble? []00:25:07]

And the reason they’re in trouble, and this was discussed some this morning, is that all sixteen nations that adopted the Euro, gave up their sovereign currencies in favor of a stateless currency. The Euro is a stateless currency. It is a fiat currency in that it is non-convertible. You don’t get to take it in and ask for gold at the end of the day, or any other commodity. But, it is not a sovereign currency in the way that the U.S. currency is sovereign, and that imposes certain constraints on the governments that use this currency. [00:25:41]

It means the default risk, solvency, is a legitimate problem for the governments that use this currency. Every one of them, not just Greece and Portugal, but Germany and France as well – every one of them could default on their debts if they’re unable to raise enough money by either taxing or borrowing from those who already have Euros. They must borrow or raise taxes; they must collect money before they can spend. It’s the only way they can do it. They are all users of their own currency. They are the users of their currency, much like California, Illinois, New York, New Jersey – they’re just like states in the United States. They’re in the same relationship relative to the currency as are individual states in this country. [00:26:31]

This is the hierarchy of money. So the entire thing in Euroland is denominated in Euros. For any particular government, look at the hierarchy of money. What is it that sits at the top of the hierarchy? It’s the Euro. What is the relationship between the currency at the top of the hierarchy and the government? In this example, the government does not control the currency that sits at the top of the hierarchy. And that turns out to be a huge problem for Greece. [00:27:03]

And we’ve seen problems with other currencies, not just the Euro, but we saw problems with Mexico, 1995; we saw problems with Russia in 1998, Southeast Asian currency crisis in ’97. They all issued paper currencies. But why did they have problems? Why did Russia default? Why were there currency crises? Isn’t that inconsistent with everything I’ve said? No, because I said that the currency needed to be a fiat currency, non-convertible, floating exchange rate. Non-convertible. Every one of these countries had fixed exchange rates. And, as a result, every one of their governments became the users rather than the issuers of their currency. [00:27:45]

I don’t know of a single example of a currency crisis or a debt default by a sovereign government that has issued obligations in its own currency when it has flexible exchange rates in a non-convertible currency. I don’t know of one. The U.S. can control its currency and therefore, by implication, its economic destiny. [28:11]

There is a relationship between the power the state has in the monetary sphere and the power that it can exert in the political policy sphere. There is no revenue constraint for governments that control the money that sits at the top of the hierarchy. Does that mean that we should spend without limit? No. No. Emphatically no. As the economy recovers, spending will need to be regulated to prevent inflation. But I would argue, and I think what we’re all here to argue today is that it’s time to stop allowing the monetary system to limit our range of policy options. It is causing unnecessary human suffering and it’s time for us to begin to recognize the advantages of a Modern Monetary System. Thank you. (Applause) [29:00]

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