Why some nations are at risk of default on their national debt and others are not. Plus why the U.S. national debt will never be repaid.
In this episode you’ll learn:
- Why the federal government is not like a household or business.
- Why the federal government should focus on economic growth and inflation and not fiscal soundness.
- Under what circumstances have nations defaulted on their national debt.
- How federal governments can print money by coordinating with their central bank.
- What is helicopter money.
Show Notes
Functional Finance and Federal Debt – Abba B. Lerner
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Summary Article
Why the U.S. Will Not Repay The National Debt
One of my favorite economists is Abba B. Lerner. He was born in 1903 in Romania and emigrated to Great Britain when he was three. He turned to economics after pursuing work as a tailor, Hebrew teacher, typesetter and operating his own printing business.
His printing business failed leading up to the Great Depression so in 1929 at the age of 26 Lerner enrolled in a night class at the London School of Economics partly to learn why his business went bankrupt. He continued at the London School, studying under famed economist Friedrich Hayek.
In 1937, Lerner emigrated to the Unites States where he continued studying and writing on economics. In 1943 in an article titled “Functional Finance and Federal Debt” Lerner expanded on a radical idea that many opposed because “they are easily frightened by the fairy tales of terrible consequences.” He acknowledged the idea was extremely simple, but its simplicity caused the public to “suspect it as too slick.”
A Simple, but Radical Idea
What was the idea? “Government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of new money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine of what is sound and unsound.”
Too often we assume the federal government is like a business or a household with the same budgetary, balance sheet and solvency constraints as businesses and households. The major difference between businesses and households and the federal government is the federal government has a monopoly on the nation’s currency.
What is sound and unsound for businesses and households (and even local and state governments) differs for the federal government because they operate with Uncle Sam’s money. The federal government plays by different rules. Such incredible power comes with a serious responsibility.
Federal Government's Responsibility
What is that responsibility according to Lerner?
“The first financial responsibility of government (since nobody else can undertake the responsibility) is to keep the total rate of spending in the country on goods and services neither greater than or less than that rate which at the current prices would buy all the goods and services that is possible to produce. If total spending is allowed to go above this there will be inflation, and if it is allowed to go below this there will be unemployment.”
“The government can increase total spending by spending more itself or by reducing taxes so that taxpayers have more money left to spend. It can reduce total spending by spending less itself or by raising taxes so that taxpayers have less money to spend. By these means spending can be kept at the required level, where it will be enough to buy the goods and services that can be produced by all who want to work, and yet not enough to bring inflation by demanding (at current prices) more than can be produced.”
Businesses produce goods and services based on the anticipation that there will be a market for those goods and services. Most of those goods and services are bought by households and businesses. Some of the goods and services are bought by the government. If the demand for goods and services exceeds the supply available, then capacity is constrained, prices rise and inflation ensues. If the supply of goods and services exceeds demand, then businesses discount prices to drive sales and they lay off workers, increasing unemployment.
Lerner argues the federal government can help ensure demand meets supply through its spending and taxing decisions, keeping both unemployment and inflation at bay.
Does that mean the federal government should try to assess supply and demand and centrally plan a response? No. That would be an extremely difficult task.
Lerner’s focus is on the total spending on goods and services within the economy, the vast majority of which are purchased by the private sector. The federal government can help ensure a supply/demand equilibrium by providing a safety net for those who are out of work through unemployment benefits and by encouraging more spending by households and businesses by cutting taxes.
The National Debt
One of the most important things government officials and citizens can do is recognize the federal government is not a household and business and consequently does not face the same constraints.
Most of the time due to the spending and saving decisions made by the private sector, the federal government will run a budget deficit. Year in and year out. Each year’s budget deficit gets added to the national debt.
The national debt will never be repaid. Why? Because in order to repay the national debt, the federal government would need to run budget surpluses for years. That means the government would have to raise taxes and extract more money from households and businesses than it spends. Households and businesses would have less money, leading to lower total spending for the entire economy and reduced overall demand for goods and services.
Sensing lower demand, businesses would lay off workers. Unemployment would rise, leading to automated increases in government social safety net spending. Household and business income would fall, leading to lower government tax revenues. The ill-planned federal budget surplus would quickly turn to a deficit and once again the national debt would increase.
The only time the government should raise taxes and run a budget surplus is if total demand for goods and services exceeds supply, causing constrained capacity and inflation. Raising taxes should never be done to “fix” federal government finances in order to make it financially sound.
Households, businesses and local and state governments need to be financially sound because they don’t control their own currency. Federal governments who control their own currency should focus on economic growth and controlling inflation; not soundness. But can't a country's national debt get out of control, leading to default?
When Countries Default
Yes. Countries who have defaulted on their national debt did so because they didn’t control their own currency, their debt was denominated in a foreign currency or the government stoked hyperinflation inflation by spending well beyond the capacity of the private sector to produce goods and services.
When a country issues its own fiat currency and issues debt in that currency, then it is nearly impossible for a country to default on its debt as long as the government keeps inflation at bay by spending and taxing responsibly. Why? Because a country who issues its own fiat currency has the power to print money, including to print money to pay off its debt. In fact, a country that issues its own fiat currency doesn’t need to issue debt at all.
Printing Money
What does it mean for a government to print money?
In today’s world of mostly electronic commerce, it means changing the numbers in the recipient’s bank account. Money is digits. It can be created at will by banks through their lending activities and by the federal government through its spending in coordination with the central bank.
This idea can be terrifying, which is why so often we default to the analogy that the federal government is like a household or business.
When households and businesses spend, they need to have the money in their bank accounts because they don’t control their own currency. The federal government doesn’t face the same constraints.
As we saw with quantitative easing, the Federal Reserve can create money out of thin air and use it to buy government bonds that banks hold. There is no reason from a technical standpoint, the Federal Reserve couldn’t create money that it provides directly to the federal government, who could then spend it, either on goods or services or to pay off debt.
Adair Turner, of the Institute for New Economic Thinking, explains three ways this could work in his paper, “The Case for Monetary Finance – An Essentially Political Issue”:
“The central bank directly credits the government current account (held either at the central bank itself or at a commercial bank) and records as an asset a non-interest bearing non-redeemable “due from government” receivable.”
“The government issues interest-bearing debt which the central bank purchases and which is then converted to a non-interest-bearing non-redeemable “due from government” asset.”
“The government issues interest-bearing debt, which the central bank purchases, holds and perpetually rolls over (buying new government debt whenever the government repays old debt), returning to the government as profit the interest income it receives from the government. In this case the central bank must also credibly commit in advance to this perpetual rollover.”
The Debt Difference Between the U.S. and Europe
Given the U.S. governments ability to access unlimited money from the Federal Reserve, holders of U.S. government debt should not be overly worried about default.
They should be more worried about the inflation that could result if the government creates too much money at a time when the private sector is already producing goods and services near its capacity to do so.
Conversely, holders of debt issued by members of the European Union should be worried about default. These countries, such as Greece, have issued bonds in a currency over which they do not have ultimate control. The governments cannot coordinate with their respective central banks to print money to meet debt obligations.
Related Episodes
Federal Reserve Insolvency and Monetizing the National Debt
The Great National Debt Debate
The Debt Ceiling – What Happens If the U.S. Defaults
