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The Path to Prosperity, part 1

by on January 27, 2013

No matter what, every dime the government spends becomes someone’s income. In fact, every dime that anyone (or any entity) ever spends on ANYTHING is someone else’s income. It is an accounting tautology that aggregate income = aggregate expenditures. This follows from double-entry bookkeeping, the universal accounting standard which gives money value (though it is NOT what determines money’s exact value- it simply allows money to hold any value at all). Remember that, absent double-entry bookkeeping, I can mark up my own balance sheet as much as I want, and make myself as nominally ‘rich’ as I want, though it won’t matter, because so can everyone else, and money will quickly become meaningless once they do.

When we talk about government ‘waste’, we often discuss it in terms of the superfluity of various expenditures relative to others. For example, many consider defense spending to be ‘worth it’, but not funding for the Public Broadcast Network. We often speak in terms of ‘bang for the government buck’, while forgetting that the buck, itself, actually ‘bangs’ as well. We tend to focus on what is probably best termed ‘financial waste’, rather than real economic waste, and we tend to think of government spending as something for which the government should receive some sort of return, but this is backwards. Just as parents sacrifice to provide for their children, so too should the government weigh the benefits and costs to the private sector of expenditures and taxation, rather than thinking in terms of costs & savings to the government.

Sovereign national governments all possess the potential for monetary sovereignty. All that is required is a national government that is capable of enforcing its own laws, particularly the payment of taxes (which creates demand for the currency- more on this later). Any national government that ‘counts’ as a government (any entity having the powers of government) can do this, by force of political will and appropriate legislation (or decree, depending on the system of government).

Three key points emerge here:

  1. Government spending affects not only the government’s balance sheet, but also that of the non-government or private sector.
  2. Non-monetarily sovereign national governments can always make the political choice to become monetarily sovereign.
  3. Monetarily sovereign governments need not ‘worry’ about their own balance sheets at all as long as A) all the debts they hold are denominated in the domestic currency in which they are sovereign (the ‘home currency’), and B) the home currency is accepted by the public at large.

Let’s take a closer look.

1. Government spending affects not only the government’s balance sheet, but also that of the non-government or private sector.

Gross domestic product, or GDP, is not only a measure of output (sales), but also one of income, by identity. GDP = Y, where Y is aggregate income. GDP is comprised of the net yearly balance change (flow) of three all-encompassing sectors (from a domestic perspective): the private sector, the foreign sector, and the government sector. This relationship is represented by the equation C + S + T = C + I + G + (X – M), which simply equates one measure of GDP with another, based on ’sources’ and ‘uses’ of income, respectively (don’t worry- these variables will be defined below). Rearranging a certain way (remember from algebra, the Cs will cancel out because they’re on both sides), we end up with what is called the ‘sectoral balances equation’ of national accounts: (S – I) = (G – T) + (X – M), which can also be set to zero: (I – S) + (G – T) + (X – M) = 0.

(X – M) is the foreign sector balance. X is exports, M is imports, and X – M is net exports, which amounts to net income from international trade, and is an inflow of money when it’s positive, which is called a trade surplus. During a trade surplus, more money is coming in to pay for exports than is going out to pay for imports (X > M), while a trade deficit is the opposite (M > X). Trade surpluses add money to the domestic economy (while removing real goods & services), while trade deficits remove it (while adding real goods & services).

(G – T) is the government balance, also sometimes referred to as the budget surplus (when T > G) or deficit (when G > T). G is government spending, and T is taxation. When the government runs a deficit, money is added to the domestic economy, when it is in surplus, money is removed- just as with the foreign sector balance, but inverted.

(S – I) is the private sector’s net saving, which is the change in private net financial assets (savings, i.e. financial wealth). S is saving, and I is capital investment (investment in future production- the kind that creates jobs). When I > S, the private sector is in deficit, which means that either the other two sectors combined are causing money to leave the domestic private sector economy (net surplus against the private sector), or the private sector is decreasing it’s debt faster than it is saving (called deleveraging), either of which amounts to the private sector losing income (as opportunity cost) and/or wealth, and therefore becoming poorer (particularly with a growing population). When S > I, the private sector is in surplus, and is accumulating net financial assets and therefore becoming richer.

For simplicity, say we ignore the foreign sector to more clearly analyze the effects on the private sector of government spending and taxation (a situation with no foreign trade is called a closed economy). In this case, our sectoral balances equation only contains two sectors, and looks like this: S – I = G – T. This says that the private sector balance (net saving) is equal to the government sector deficit (remember, if G > T, the government sector is in deficit, so if G – T is positive, that is a government sector deficit).

In order to drive the point home, let’s assign a new variable for each side of the equation, such that S – I = GD (government deficit), and G – T = PSB (private sector balance). This is just a different way of saying the same thing. Clearly, the private sector balance is equal to the government deficit, or PSB = GD. Incorporating the foreign sector in the trade balance form (where we count net exports, X – M), and represented as NX, we can say that PSB = GD + NX.

Another way to say this is to say ‘the private sector balance is equal to the government deficit plus the trade surplus (or minus a trade deficit)’.

2. Non-monetarily sovereign national governments can always make the political choice to become monetarily sovereign.

In the absence of outright slavery, government operations require government expenditures- you can’t get people to work for you unless you pay them (or they are politically loyal to you and willing to volunteer- but this doesn’t last forever). There are two ways for a government to fund itself- by acquiring and distributing existing assets of value, or by issuing new assets of value (money). Either method must be deliberately defined by either the national constitution (or other establishing documents) or by legislative authority.

It should be noted that there is nothing in nature that defines money, or how governments can or must acquire, use, or create it. Money is not organically emergent- it is a creation of humankind, to solve problems of humankind. Therefore, humankind sets its own rules for money. Only political will can allow or prevent a sovereign government from being monetarily sovereign- nothing else. A government can’t avoid making this choice, either- it must have the power to either create or acquire money in order to operate functionally; a government without this power is not sovereign at all, and cannot manage to fund its own operations. Therefore, if a government exists and is sovereign, then somewhere along the way the choice was made to either exercise monetary sovereignty, or to restrict the exercise of monetary sovereignty. Failing to make this decision is tantamount to failing to make a functioning government.

This decision is expressed in the United States Constitution:

The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises…[and] To coin Money, [and] regulate the Value thereof.

(US Constitution, Article I, Section 8)

The first section, to the left of the ellipsis (…), “The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises” empowers the government to acquire existing money, while the second part, “To coin Money, [and] regulate the Value thereof.” grants the power to create new money.

And be it further enacted, That the money of account of the United States shall be expressed in dollars and that all accounts in the public offices and all proceedings in the courts of the United States shall be kept and had in conformity to this regulation.

(Coinage Act of 1792, Section 20, US Code)

This clause, from the Coinage Act of 1792, is an expression of the federal government exercising the power granted it by the preceding clause from the Constitution. It defines the money that the government will use- and accept as payment- for all public accounts (and therefore, all public transactions). Since it defines a new currency, it is defining a state money– one to be issued & destroyed by the government, and via charter granted by the government.

Note that neither of these clauses establishes what, if anything, ‘backs’ the value of the state money- the actual nature of the monetary system is still not explicitly defined, though we can infer it. Thus far, it has been established that the government has the power to establish the home currency, regulate the money, and issue tokens of it. Since nothing in nature defines money, and it is therefore left to governments to do so, a government subject to the above clauses can, in fact, issue its own money- absent any further legislation which might explicitly exclude such authority.

It so happens that the US Congress has passed several such laws over the centuries, switching several times between fiat and gold-standard monetary systems.

3. Monetarily sovereign governments need not ‘worry’ about their own balance sheets at all as long as A) all the debts they hold are denominated in the domestic currency in which they are sovereign (the ‘home currency’), and B) the home currency is accepted by the public at large.

A government sovereign in its own currency cannot involuntarily default on debts or obligations denominated in the currency in which it is sovereign. Imagine a citizen who owns an ‘official’ printing press and can print legal currency at will, with no laws that forbid him to do so. Can he ever be forced into default, if he only ever takes out debts in the currency he can print? Why should he even borrow in the first place, since he can print currency at will and on demand? The answer to the former is ‘of course not’, and for the latter, there is simply no reason for him to do so- unless he means to do the creditors a favor.

This logic also applies to governments which choose to exercise their monetary sovereignty- and by extension, to all sovereign governments, since all sovereign governments can, at any time, choose to switch to fiat money and thereby have the ability to issue new money at will, given the political will to do so.

There is no financial constraint to a monetarily sovereign government. The only applicable constraints are inflation, currency acceptance, and the real resources available to the domestic economy- land, water, copper, oil, labor, and so forth. As long as the public accepts the home currency, the sovereign government can issue & spend it, without specific constraint. As long as there are idle workers and production capacity available, such money creation will not cause demand-pull inflation (commonly described as ‘too much money chasing too few goods’), because producers have a very strong incentive to increase output before they increase prices when faced with rising demand for their products. That means cranking up production in the factories and hiring more workers, which distributes more income through the private sector, which in turn leads to a further rise in demand, and so on. If some producers chose to increase prices before increasing output, they would quickly lose market share to their savvier competitors (who have lower prices), and therefore lose profits. While some make this mistake, the business world in aggregate knows better, and so increased demand leads to increased employment, as long as the appropriate real resources are available for production.

There is one last point to cover, which serves to explain the relationship between money creation & distribution and economic development, growth, & job creation:

4. In aggregate, the desire to save crowds out all other factors to whatever extent is possible.

The ‘desire to save’ is economics code for ‘we all want more & better for ourselves’. It is the embodiment of the will to accumulate, the drive to get rich or richer, and the push for a constantly improving standard of living. People generally wish to be better off in the future than they were in the past, and this manifests as the desire to save. The accumulation of net financial assets (wealth) is the general economic goal of virtually everyone, and its fulfillment is what allows economic growth through consumption, investment, and subsequent job creation.

During economic contractions, the poor lose income (and cannot afford to save), the middle class loses income and saves more than usual (in order to ‘tighten the purse-strings’ in the face of an uncertain economic future), and the rich lose income (because the other classes are spending less), invest less (because since the other classes are spending less, there is less viable investment opportunity available in the face of an uncertain economic future) and thereby save more (because investing in growth in the context of a downward moving market is generally foolish). In aggregate, this process amounts to a reduction in consumption, and thereby job losses and massive unemployment. If nothing external causes private sector behavior to change, and since the trade balance is largely left to ‘float’, rather than being actively managed, the only remaining sector capable of restoring aggregate spending, consumption, and job & income growth is the government.

Deficit spending by a monetarily sovereign government is the key and necessary component to restoring economic growth and prosperity under such conditions. It literally provides additional income to the private sector, and does not contribute directly to inflation when production is significantly below capacity. There are other factors at work, such as private debt levels and the distribution of the deficit spending (i.e., who gets the money), but without deficit spending, sustained and equitable economic growth is impossible.

It is clear that as long as a national sovereign government chooses to issue its own currency and thereby exercise monetary sovereignty, there is no hard budget constraint. Such a government can never run out of the home currency, can never be forced into default on debts denominated in the home currency, and is never subject to a financial constraint with regards to its spending. Such a government holds the power to create full employment, price stability, and an equitable distribution of national prosperity.



image credit: unknown

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