Frank N. Newman’s slim and sensible book Freedom from National Debt should be mandatory reading for anyone who wants to express an opinion about government spending, deficits and debt. Newman’s exposition also echoes the aspiration of this blog in three immediately apparent ways. First, he’s the kind of economist who trained as a mechanic before presuming to be a scientist or engineer. Whereas the representative economist is the obnoxious and ill-proportioned Porsche driver who wouldn’t know how to pop the bonnet, Newman strikes me as the roadside assistance mechanic who would patiently change the battery while hearing that our driver ‘already knew how to do that’.
Second, rather than investing his considerable mental capital in academia, Mr. Newman devoted it to developing a close understanding of how the government and the private sector actually spend, aided by three decades of experience in the US Treasury and the banking sector. Third, informed by this reality, Newman sensibly and rigorously answers the question: ‘How is the government going to pay for it?’ In so doing, he awakens the economic possibilities that most governments (and many citizens) don’t realise are within their grasp.
Freedom from National Debt offers its reader precisely that. Bill Hicks would approve.
These tributes shouldn’t be read as an appeal to authority. While Freedom from National Debt shows how we can all enjoy a better ride, it’s the logical mechanics getting us there which matter. While I highly recommend buying the book in the original (the Kindle edition is A$4.01 at time of writing), because descriptions of government spending, taxing and bond sales tend to read like your car’s service manual, in this blog post I’ll distil the main points, punctuated by the occasional gif.
We can best understand the economy Newman presents by dividing it into a public and a private sector. The public sector consists of the government and the central bank. Newman’s focus is on countries with their own central banks, which issue a currency that’s not fixed to the value of another (or to the value of gold). Such a currency is convertible only into more of itself. Countries with these arrangements include Australia, Canada, Japan, the United Kingdom and the United States. In addition to the public sector, Newman specifies a private sector, comprising private banks, along with households, firms and the overseas sector. This setup has an implicit hierarchy.
At the top of the pyramid is the government, which names the currency, demands that all taxes be settled in it, and empowers the central bank to issue it. On the second layer is the central bank which, in addition to currency issuance, manages the government’s accounts and the reserve accounts of all private banks in the economy. Private banks occupy the third layer of the pyramid, because they also create money every time they grant a loan, although this is done with an accounting ledger, rather than with physical currency. When an agent in the private sector wants to buy a house, a car, or anything requiring a bank loan, a private bank simply scribbles the money into existence. The private sector agent has a new deposit, created ‘from nothing’, which he or she uses to pay the seller. The private sector agent also has a new debt, equal to the amount of the loan, which eventually must be repaid. Accordingly, filling out the base of the pyramid are private sector households, firms and overseas agents, who use domestic money, but cannot issue it, no matter how hard they might try.
How they spend
This four-layer pyramid therefore consists of two ‘money issuers’ (private banks and the central bank) and two ‘money users’ (the rest of the private sector, as well as the government, under current arrangements). Money issuers lend money into existence, whereas money users merely shuffle existing money around.
Let’s look at this pyramid in more depth, starting from the base.
Private sector (money users)
When you or I spend our hard-earned cash, we’re just transferring a portion of our existing deposits to someone else. The total amount of money in the system is unchanged. If you’re fortunate enough to have a job, where did your salary come from? Probably your employer’s bank account. And how did your boss get that money? Most likely from customers who paid for your company’s goods and services. And those customers probably had money because they had jobs, with bosses who paid them… Without the intervention of a bank creating a loan, we’re quickly chasing our tails. Where did the money that you and I spend originate? While you might rightly see yourself as a ‘wealth creator’, neither you, nor your boss, is a money creator.
Sure, firms might issue corporate bonds to finance some of their activities, but the households buying these merely transfer their own deposits into firms’ bank accounts. No new money enters the system in this way. Similarly, a household buying shares or government bonds is making a portfolio allocation decision using already existing deposits No new money enters the system in this way either.
Private banks (money issuers)
Private banks have the power to create new money whenever they ‘spend’. Most often this happens when banks interact with households and firms (who can’t issue money). To reiterate, when a bank grants a home loan or buys corporate bonds, it simply adds new money to the deposit side of its ledger, which the deposit holder can then use to spend. Whenever a private bank lends, total money in the system increases.
The central bank (a money issuer)
The central bank is the public sector counterpart to a private bank, in that it also creates new money when it spends. But the central bank has additional responsibilities: managing the government’s bank account; managing the reserve accounts of private banks; and acting as a ‘lender of last resort’ to private banks when they can’t sort out payments between themselves.
We’ll assume, in the spirit of realism, that the central bank avoids lending directly to the government, which compels the government to fill its own bank account with private sector funds if it wants to spend. This is the conventional practice in Australia, Canada, Japan, the United Kingdom and the United States.
The government (a money user?)
The government of these countries is at the top of the money tree. By making laws about the currency it will receive taxes in, and by entrusting issuance of this currency to the central bank, the government should be considered as the ultimate issuer of the currency in the countries mentioned above. However, institutional arrangements, entered voluntarily by these governments, make them appear as though they’re mere money users. So we’ll treat them as such.
Therefore, in order to spend, the government offers bonds to the private sector in exchange for deposits in its own account. When the government ‘deficit spends’, it transfers this newly obtained money right back into private sector accounts. The deposits of the government are unchanged. The deposits of the private sector are unchanged. Total money in the system is unchanged. But now the private sector has a new asset–government bonds–and the government has a new debt of identical size. (The one that we’re supposed to be afraid of.)
Should we fear government debt?
Immediately, we can see one reason public debt might not be as scary as it seems: government debt is a private sector asset. But scaremongering about the increasing value of our assets just doesn’t seem as newsworthy.
Nevertheless, two rational fears remain, which should be addressed: how does a government like Australia’s pay interest on its debt? And what happens if bondholders decide to sell up?
Government bond sales in Australia are always very popular with investors. Because there’s never a question of ‘where the government is going to get its money from’, investors can be confident that they’ll always receive the interest and the principal. (Most investors simply roll maturing bonds over.) If some investors do want to cash in their bonds, the government provides them with this money, including any interest payments…and it obtains this money by issuing yet more bonds! Interest payments do not consume any part of the government’s finances that would have otherwise been spent on real resources.
Nevertheless, at first glance, this looks something like a Ponzi scheme. Paying off debt by issuing more debt is surely the road to ruin! Won’t the charade eventually fall apart? What if all Australian bondholders were to sell their bonds en masse?
Let’s say this favourite worst nightmare of the fiscal conservatives comes true and all Australian bondholders redeem their stakes. The government would simply provide these people with Australian dollars. It’s a straight swap of one Australian government asset (a bond) for another (a deposit), with some help from the central bank. The government is in no better or worse position to spend than it was before. The reason the government could repay investors in this unlikely event–because the central bank is the ultimate source of Australian dollars, and it’s ultimately a creature of the state–is the very reason most investors won’t cash in their bonds. (The story is different for Europe.)
But if investors do sell up, they now have a bundle of Australian dollars, with which they can do three things: (1) buy Australian goods and services; (2) invest in other assets denominated in Australian dollars; or (3) exchange Australian dollars for a foreign currency. If they exchange Australian dollars for a foreign currency, the other party to the exchange faces the first two choices. And so it goes. The only way Australian dollars will ever leave the system is if bank loans are repaid. Just as private banks and the central bank were the only two entities bringing money into the system, they are the only two entities through which money can leave.
The bottom line: Freedom from national debt?
I’ve not done much justice to Newman’s fantastic book. Buy it if you can. But if nothing else, remember the following.
Governments with their own central banks, issuing a currency that’s not fixed to the value of another currency (or to the value of gold), will always be able to pay their debts. Sensible investors know this, which is one reason why government bonds are still so popular in Japan, a country which boasts a government debt-to-GDP ratio of around 175 per cent, but also boasts the only central bank that issues yen (in which the debt is denominated). The eurozone nations are in a different position. Greece, Spain and Germany don’t have the capacity to issue euros, so unless the ECB is in a financially stabilising mood, there’s no guarantee that these countries will repay their debts if investors cash in their bonds.
For governments with monetary systems similar to Japan’s (or Australia’s), the only risk of excessive spending is inflation, not insolvency. But excessive private sector spending is no less of an inflation threat. The small-government people might have neglected to mention that. But to give them some credit, just because the government can buy everything it wants, doesn’t mean that it should. Inflation is a reasonable fear, regardless of its source.
As households and firms, you and I do not effectively ‘lend’ anything to the government, at least not for long before it spends that money back, and definitely not in the sense that central and private banks lend. The money in our deposit accounts that we might choose to invest in government bonds has at some stage been put there by someone else, a currency issuer. Any money that we think we’ve ‘made’ can ultimately be traced to only two sources: (1) a private bank which at one time granted a loan to someone (whether it was you, your boss, your boss’s customers…), or (2) the government which, in concert with the central bank, once bought something from the private sector. Most of the transactions you and I make with our money merely shuffle existing deposits around.
Some might still argue that ‘freedom from national debt’ will only occur when there’s no national debt left. Indeed, that’s one policy option available to the Australian government. But I’d prefer the ‘freedom to choose’ a government that directs its money towards building and maintaining real public assets and leaves a guaranteed financial asset for the private sector as the signature of its works.