ECONOMIC AFFAIRS: by Colin TeeseNews Weekly
A debt-free way to lift output and employment
, May 25, 2013
The federal Budget will have come before parliament by the time this article is published. However, this article is about budgetary processes rather than budget specifics.
A fundamental question is this — how come our political leaders seem to know so little about managing public finance with a sovereign currency and floating exchange rates?
The subject attracted widespread public attention last year with the release by the International Monetary Fund of a 71-page discussion paper, entitled The Chicago Plan Revisited (August 2012), written by IMF researchers Jaromir Beneš and Michael Kumhof.
The idea first put forward by a group of economists from the Chicago School of Economics back in 1936, when the economies of the United States and many other countries were in the grip of the Great Depression.
The Chicago Plan proposed depriving private banks of their long-held privilege — the exclusive power to create credit. Instead, the plan would require US private banks to secure 100 per cent of depositors’ funds. Today’s fractional-reserve banking would be transformed into 100-per-cent-reserve banking.
I discussed the proposal in my article, “Radical bank reform that could help end economic instability” (News Weekly, December 8, 2012). My recent re-reading of public statements by the two most recent chairmen of the US central bank, the Federal Reserve, have prompted my further reflections on the matter.
Australia is not alone in its misunderstandings of public finance, management of money and the role of exchange rates. Most, if not all, Western economies are being managed without proper regard for these matters either.
From the end of World War II until 1971, the period during which the 1944 Bretton Woods agreement on international financial exchange operated, the 46 countries associated with it — led by the US, and including Australia — were part of a de facto gold standard.
The US dollar was convertible against gold at a fixed price and we, along with the others, agreed to tie our currency to the US dollar. This arrangement, beneficial though it was in many ways, clearly limited our control over the Australian dollar and our domestic money policy.
In 1971, US President Richard Nixon unilaterally cancelled the direct convertibility of the US dollar to gold, and thus helped end the Bretton Woods arrangement, ushering in an era of floating exchange rates that we have had ever since. In 1983, Australia, after having had a “managed” flexible exchange rate for some years, floated the dollar, after which we had our own sovereign currency.
Perhaps because we had for the first time our own currency and a floating exchange rate, successive governments have continued to manage budget and money policy as if our dollar were still tied to another currency.
They should have taken note of the comments of Alan Greenspan. Here is what Greenspan told the Catholic University of Leuven in Belgium, in a speech he made back in 1997 when he was still chairman of the US Federal Reserve.
He said: “When there is confidence in the integrity of government, monetary authorities — the central bank and the finance ministry — can issue unlimited claims denominated in their own currency and can guarantee or stand ready to guarantee the obligations of private issuers as they see fit. This has profound implications for good and ill for our economies.
“Central banks can issue currency, a non-interest bearing claim on the government, effectively without limit [my italics]. They can discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into riskless claims on the government in the form of deposits at the central bank.”
Twelve years later, Ben Bernanke, Greenspan’s successor at the Fed, said much the same thing in less technical language. In a television interview — the first by a Fed chairman — he was asked about whether the US$9 trillion he had pumped into the US banks was a taxpayer burden (counting the guarantees and purchases of toxic mortgages taken over by the Fed, which was much more than what was credited to private bank accounts at the Federal Reserve).
Bernanke said that no taxpayer money was involved. The funds were created by computer transfers to the accounts of private banks at the Fed. He was invoking precisely the Fed’s powers that Greenspan had enunciated a dozen years earlier.
He might have added that governments are not like households. To spend in their own currencies, they don’t have to borrow in order to fund expenditure greater than their earnings. They are the creators of the currency, not its users. Moreover, a so-called budget deficit does not create a liability for present or future generations. Nor should the government’s budget necessarily be balanced annually in the same way as a business or private household.
However, don’t assume that this creates some kind of promised land — a kind of dream-time socialism, where the government can give everyone as much money as they want. Governments have no licence to spend recklessly; but, when necessary, they can and should increase spending in order to maintain an adequate level of demand in the private sector and keep the economy running at full capacity.
Following up on Greenspan, governments can and should finance capital projects without recourse to borrowing. As the 2012 IMF discussion paper explains, it makes no sense for the government to borrow from, or pay interest to, others on money which it alone is able to create.
Important conclusions follow from this. Funds needed to ensure the economy reaches its full potential are always available. The government should call on them as necessary to ensure demand in the economy matches available supply. This generates necessary profits for the private sector and creates sustainable jobs. Spending money in this way is the tool the government has at its disposal.
Don’t forget that everything the government spends, one way or another, feeds demand for goods and services supplied by the private sector.
Once the economy is operating at full capacity, the opposite approach is needed. The government must curtail spending and, if needed, increase taxation, to ensure demand does not outrun the capacity of the economy to produce goods and services. Too much money chasing too few goods causes money to lose its value and prices to rise — that is, inflation.
It will be noted that these prescriptions are the exact opposite of what orthodox economic opinion today prescribes; but they do make sense. Taking spending out of the economy by taxes and spending cuts obviously reduces demand for the goods and services that the private sector can create, just as increased government spending and tax cuts stimulate private sector demand.
Adequate demand for economic output is essential if profit-based business is to prosper.
This policy may, at first glance, bear a resemblance to a Keynesian-style stimulus; but it actually is much more than that. It puts the budget process at the centre of demand management.
Does this mean that budgets need not be balanced? Absolutely not. They should be balanced, certainly over the business cycle. They will, however, not always find a balance point against revenue collections.
When the economy is under-performing, correction will be achieved by the addition of whatever extra government spending and tax cuts are needed to take up the shortfall in demand. Conversely, when the economy is at full capacity, taxes may need to be increased to the extent needed to curtail excessive demand, and take spending out of the economy.
A combination of revenue collections and government spending become the budgetary instruments for keeping supply and demand of goods and services in balance.
A moment’s reflection will reveal that nothing like this is happening in Australia — or, for that matter, in any other Western economy with a floating exchange rate and a sovereign currency.
Under the influence of Greenspan and Bernanke, the US is moving in that direction, but thus far imperfectly — at least according to senior US economist Professor Nouriel Roubini.
Roubini, in a recent column he wrote, expressed dismay at the outcome of Bernanke’s third round of “quantitative easing” (QE3). Large sums are indeed being added to the accounts of US private banks held at the Fed, but these are being lent out, in the worst possible way.
They are being lent, says Roubini, not to enterprises wanting to provide goods and services, but to borrowers wanting to speculate in real estate and shares. These particular borrowers are prepared to pay higher interest rates than are productive enterprises.
Roubini says this is pushing the US economy in the direction of a new asset price bubble such as almost destroyed the world economy in 2007 (Project Syndicate, April 29).
That is not Bernanke’s purpose, of course. He has made clear that his quantitative easing is intended to bring down unemployment and revitalise the real economy.
If this policy is not working, the fault lies not with Bernanke, still less with his policy, but with the fact that the Fed needs Congressional support to control the direction of bank lending. Left to their own devices, the banks — not unreasonably — will lend to those willing to pay the highest interest rate.
Bank regulation by the US government is the only way to ensure Bernanke’s intentions can be realised. If Congress doesn’t move on bank regulation, and if Roubini is right, the US government will be faced with another financial bubble and subsequent bust. We can only hope another financial crash is not needed to fix this problem.
Australia’s financial policy-makers would do well to follow carefully what is happening in the US rather than to take a defensive position behind our present practices.
There is much to be gained by using the policy flexibility open to us. Injections of interest-free capital are a painless way to finance the rehabilitation of our decaying infrastructure.
To do this the states need to spend money they don’t have and cannot raise. The Commonwealth could provide the funds — not all at once, but in line with ensuring a steady, annual non-inflationary growth in overall demand.
It would need to be done on the basis of realistic negotiations with the states to establish priorities for projects based on a combination of need and equity. This is no easy task, but it could result in much being done quite promptly.
This approach to funding state projects would also help fix the mess that is currently Commonwealth/state financial arrangements. For now, we are unable to deal effectively with imbalance whereby the states have responsibility for most of the expenditure burdens, while the Commonwealth has access to the money.
It will be obvious that this article has done little more than touch on how countries with their own currencies and a floating exchange rate can manage the question of public finance.
Much remains to be said, but this might be the right moment to open a debate in Australia — one which is apparently already underway in the US.
Colin Teese is a former deputy secretary of the Department of Trade.
Alan Greenspan, “Central banking and global finance”, remarks made at the Catholic University of Leuven, Belgium, January 14, 1997.
Jaromir Benes and Michael Kumhof, The Chicago Plan Revisited, IMF Working Paper: WP/12/202, (Washington DC: International Monetary Fund, August 2012).
Colin Teese, “Radical bank reform that could help end economic instability”, News Weekly, December 8, 2012.
Nouriel Roubini, “The trapdoors at the Fed’s exit”, Project Syndicate (Prague), April 29, 2013.