National Government Debt Dynamics- Causes and Policy Options

October 3rd, 2012
in Op Ed

by Warren Mosler

Editor's Note: This is a draft of presentation to be made on October 26 at a conference in Rome.  The author is looking for feedback, comments and discussion.

debt-burden-2SMALLI’ll first address what I believe is the most misunderstood question, which is why the euro national governments debts are as high as they are. 

The answer begins with the absolute fact that government debt is equal to global ‘non government’ accumulations of euro financial assets.  For any given ‘closed sector’ the euro is a traditional case of ‘inside money’, as with a ‘giro’ or ‘clearing house.’  The only way an agent could have net euro financial assets would be for another to be net borrowed.  For every euro asset there is a euro liability.  The net is always zero.

Follow up:

This type of system famously can’t accommodate a net desire to save, unless there is a provision for net financial assets to enter the sector in question.  In the case of the euro, this means the non government sector requires government deficit spending to satisfy its net savings desires, should there be any.

Additionally, note that all government spending is either used to pay taxes or remains as net savings in the economy, in one form or another.  And unemployment, as defined, is the evidence that the economy does not have sufficient euro income to pay its taxes and fulfil its net savings desires. 

The answer to why national government debt is so high continues with an investigation of the ‘savings desires’ that generate the need for net financial assets. 

European institutional structure includes powerful incentives to not spend income, and to instead accumulate financial assets.  Historically these have been called ‘demand leakages’, and include tax advantaged as well as mandatory requirements for income to go into retirement funds, corporate reserves, as well as actual cash in circulation.  Without an equal expansion of private sector debt by other agents spending more than their incomes, these savings desires can’t be realized, unless governments spend more than their income. 

In the years immediately before the euro, the member nations with today’s high debts had their own currencies.  As currency issuers, whether they realized it or not, they had no solvency issues, they set their own interest rates, and they accommodated domestic savings desires with government deficit spending, which allowed them to sustain growth and keep unemployment relatively low. 

The point here is that high deficits were offsetting the high demand leakages built into the institutional structures.  And that requirement has not gone away, as the traditional demand leakages remain.  And note that the nation with the lowest deficit, Luxemburg, never had its own currency, and instead market forces caused them to fund their net financial assets with net exports. 

What changed with the euro, and the ‘divorces’ from the national central banks, was the ability to fund national deficits.  The euro nation’s financial dynamics became very much like the US states.  They can no longer ‘print the money’, and are instead revenue constrained.  However, the difference is that, unlike the US states, the euro members entered the euro with the higher debt levels incurred when they were issuers of their currencies, not constrained by revenues, and acting to offset demand leakages as required to sustain output and employment. 

Today, the ECB is the central bank for the euro.  I often call it the ‘score keeper’ for the euro.  The ECB system spends and lends euro simply by crediting accounts.  These euro don’t ‘come from’ anywhere.  They are ‘data entry’.  As Chairman Bernanke responded when asked where the hundreds of billions of dollars lent to the banks came from:  ‘...we simply use the computer to mark up the size of the account they have with the Fed.’ 

In fact, any central bank, operationally, can make any size payments in its own currency.  When the ECB makes a 500 million euro securities purchase, no one asks where the euro came from, whether it was taxpayer money, or whether the ECB somehow borrowed it from China.  Central banks are not revenue constrained in their own currency.  This puts them in the unique position of being able to act counter cyclically during a down turn in the economy.   

Conversely, the euro members, like the US states, are not financially capable of reacting counter cyclically to increased savings desires when private sector credit expansion fails and economies slow.  Only the ECB can, as I like to say, ‘write the check’ to allow for the provision of the net financial assets demanded by the institutional structure, as evidenced by the rate of unemployment and the output gap in general.

Given the state of private sector credit and net export potential, the euro zone currently needs even higher levels of government deficit spending than otherwise to sustain growth and employment.  And only the ECB can write that check.  And yes, I realize the political difficulties this implies, the most pressing issue being that of moral hazard.

Given the necessity of more national government debt and with only the ECB ultimately capable of writing the check, I’ll now discuss policy options for closing the output gap, and their associated risks.  

A simple ECB guarantee of national government debt and an expansion of Maastricht limits to perhaps 7% of gdp would trigger an immediate surge of sales, output, employment, and general prosperity.  However, without adequate enforcement of limits, it would also surely trigger an inflationary race to the bottom, as the nation managing to run the largest deficits would benefit the most in real terms.  So the challenge is to allow the right level of fiscal expansion to accommodate the demand leakages of the independent member nations, but without the direct central fiscal control of a currency union like the US.

Tax credit bonds are another option.  These are bonds that have the same characteristics of today’s sovereign debt, but in the case of non payment (there is no default condition) these fully transferrable bonds can be used for payment of taxes to the government of issue.  This means that taxpayers of other members will never be asked to pay any other member’s obligations, which I presume would have wide political appeal.

A third option is for the ECB to make ‘cash’ distributions to the member nations on a per capita basis of perhaps 10% of euro zone GDP annually.  This would begin a systematic reduction of member deficits towards 0 over a multi year period.  It would also have to include strict spending limits to regulate aggregate demand.  To that end, the ECB could withhold payment to violators, which is far easier to do than imposing and collecting fines, as is the case today.       

20 years ago I was in Rome at the finance ministry meeting with Professor Luigi Spaventa, along with my colleague Maurice Samuels of Harvard Management.  Those, too, were dark days for Italy.  Debt was over 100% of GDP, interest rates over 12%, the global economy was weak, and Professor Rudi Dornbusch had been making the rounds proclaiming that Italian default was certain.  I asked Professor Spaventa, rhetorically, why Italy was issuing CCT’s and BTP’s.  Was it to fund expenditures, or was it because if the treasury spent the lira, and did not issue securities, and the Bank of Italy did not sell securities, the overnight rate would fall to 0?  There was a long pause before Professor Spaventa answered ‘no, rates would only fall to ½% as we pay interest on reserves’ indicating full and sudden understanding that there was no default risk.  He then immediately rose with an attack on IMF conditionality.  A great weight had been lifted.  The next week it was announced ‘no extraordinary measures would be taken- all payments will be met on time” and the debt crisis receded.

Solving that debt crisis was relatively easy, as in fact there was no debt crisis.  Today the situation is both more serious and more complex.  The economic problem is that deficits are too small, while the political understanding is that deficits are too large.  And the consequential ECB funding with conditionality translates into lower rates and higher unemployment.

Note that I have made no mention of interest rates or monetary policy in general.  My 40 years of experience as an insider in monetary operations tells me they matter very little for growth and employment.  And for nations with high deficits, I’ve come to expect high rates from the CB to function to promote inflation from both the interest income channels, and through the general cost structure of the economy.

I will conclude with very brief word on inflation.  Just like the dollar, yen, and pound, the euro is a simple public monopoly.  And any monopolist is necessarily price setter, not price taker.

Furthermore, a monopolist sets two prices.  First is what Marshall called the ‘own rate’ which is how the monopolist’s thing exchanges for itself.  For a currency that is the interest rate set by the CB. 

The second is how that thing exchanges for other goods and services.  For a currency we call that the price level.  I say it this way- the price level is necessarily a function of prices paid by the government of issue when it spends, and/or collateral demanded when it lends.

What this means for the euro zone is that inflation control ultimately comes down to limiting government spending by limiting selected prices member nations are allowed to pay when they spend. Like central banking, it’s about price, and not quantity.

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About the Author

Warren Mosler is co-founder and Distinguished Research Associate ofThe Center for Full Employment And Price Stability at the University of Missouri in Kansas City. CFEPS has supported economic research projects and graduate students at UMKC, the London School of Economics, the New School in NYC, Harvard University, and the University of Newcastle, Australia. He is Associate Fellow, University of Newcastle, Australia.

Warren is the founder and principal AVM, L.P., a broker/dealer that provides advanced financial services to large institutional accounts. He is also founder and principal of Illinois Income Investors (III), specializing in fixed income investment strategies for 29 years. He is presently located in the U.S. Virgin Islands where he heads Valance Co, Inc., the corporation that owns the shares of III Offshore Advisors and III Advisors, the companies that manage AVM and III.

Warren has a degree in economics from the University of Connecticut. He has 38 years of experience in a variety of fixed income markets, including derivatives. He writes at his blog and widely in the press and blogosphere. Warren is considered to be the founder of Modern Monetary Theory (MMT). You can read a longer bio here.

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  1. Explorer says :

    Great article.

    I would like to see it expanded to deal with intra EMZ trade deficits and a discussion of Target2 balances.

  2. Sigmund Silber says :

    The first part of the paper is excellent the second half is kind of silly to me.

    What is the point of tax credit bonds. That may make it easier to sell bonds but it basically eliminates the potential to default since you reduce both debt and tax revenue.

    A handout to everyone would reduce personal indebtedness but not necessarily increase aggregate demand.

    And the first option is happening without any permission being granted. It is a stimulus program and either moves debt from the Center to the Periphery or you just create more money and either have inflation or a decline in velocity of money.

    Those have nothing to do with competiveness, demographics or any of the real issues.

  3. Derryl Hermanutz says :

    Sigmund wrote, "Those have nothing to do with competiveness, demographics or any of the real issues."

    You are of course correct. These are the "economic" factors that caused the current "financial" crisis, if you agree (as I do) that the goods and services producing economies are ultimately the "real" concern and financial imbalances are simply the consequence of the economic imbalances. Some people produced and earned more than they consumed, so they became savers and creditors. Other parties consumed more than they produced and earned so they became spenders and debtors.

    But "money" is the real economy's nervous system. Money that is offered and spent signals the economy to go to work producing that which is demanded by the spenders of money. Spending money can be either "earned" by the spender or "borrowed" by the spender. A financial crisis occurs after some parties have been borrowing and spending too much, and other parties have been earning and lending too much, and it becomes obvious that the borrowers and the earners are never going to switch positions with each other so that the earners/lenders become net recipients of money and the borrowers/spenders become net earners and repayers of money. The borrowers/debtors cannot earn the money they need to repay their debts if the earners/savers are not "spending" their savings.

    Some people are by nature earners/savers ("Germans") and other people are by nature borrowers/spenders ("Greeks"). Once the productive Germans have all the money and are owed all the debts, and Greeks have bought all the German economic surpluses and now owe all the debts, the only way for Greeks to get the money to repay their debts is if Germans suddenly become spendthrifts and spend all their savings back into the Greek economy so Greeks can earn incomes and repay their debts.

    But what can Greeks produce that Germans want to spend all this money on? And how do you convince Germans to lay back, stop working and producing, and let the industrious Greeks export what Germans need into the German economy? Germans would have to become net importers of Greek economic outputs, and Greeks would have to become net exporters to Germany, for this to work. But Germans are not going to become Greeks and Greeks are not about to become Germans, so this "economic" role reversal is NOT going to happen.

    The "economic imbalances" are baked into the eurozone cake. In the pre-euro days the drachma would have lost fx value against the mark so that German imports became prohibitively expensive to Greeks and Greek exports and holidays became attractively cheap to Germans. Changes in the relative values of their currencies would have automatically prevented Greeks from getting so far in debt and Germans from getting so far in credit.

    So the "real" economic issues cannot be fixed because of the basic human natures of the parties involved in the economic-cum-financial imbalances. And the "financial" issues are no longer self-correcting because of the single currency eurozone. So here we are in the ensuing financial crisis, where the spenders can't spend anymore and the earners can't earn anymore, because one party's spending is the other party's earning. How do you end this economy-stalling deadlock between debtors and creditors?

    Mosler is advocating solutions to the financial crisis because solving the financial deadlock will unlock the economies and get them working again. Right now money is signaling to the economy "STOP!", because money is not being offered or spent. We have agreed that the "real" goods and services producing/consuming economies are the "real" issue, and the financial consequences are secondary, so can we agree that it is rational and desirable to apply financial intelligence to get the economies working again?

    It is impossible to make Greeks and Germans switch natures and switch their roles to correct the economic imbalances. But it is technically very easy to fix the financial crisis by methods that Mosler is proposing. I say let's fix what's fixable rather than bang our heads against the impossible.



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