Introductory Series: On Private Debt and the Mismanagement of the US Economy
[Since this discussion is well over ten thousand words long, I have edited the complete text and in one case, rewritten the section on Minsky and financial instability in a language suitable for the general public, shortening it considerably, as well as broken the discussion down into three parts. I will finish editing and post parts II and III as time permits.]
Understanding the Basic Dynamics of the Macroeconomy
Consumer spending is an essential component to the economy. If consumers as a whole spend more, more jobs are created as a result, since businesses are pressured by that spending to increase their production. If consumer spending as a whole begins dropping, the pressure on businesses to produce is relaxed and so, jobs are not created, but rather, some jobs are lost. If consumer spending as a whole continues falling, job creation is negated and unemployment will continue rising. So, consumer spending is what we refer to as aggregate demand. But it is important to note that consumers do not control aggregate demand. They are action devices, so to speak. On the whole, when you put increasing amounts of money in their hands over and above what they desire to save, they will increase their spending. If you take away money in ever increasing amounts, they will begin saving on the whole and reduce their spending.
Consumer spending is an essential component to the economy. If consumers as a whole spend more, more jobs are created as a result, since businesses are pressured by that spending to increase their production. If consumer spending as a whole begins dropping, the pressure on businesses to produce is relaxed and so, jobs are not created, but rather, some jobs are lost. If consumer spending as a whole continues falling, job creation is negated and unemployment will continue rising. So, consumer spending is what we refer to as aggregate demand. But it is important to note that consumers do not control aggregate demand. They are action devices, so to speak. On the whole, when you put increasing amounts of money in their hands over and above what they desire to save, they will increase their spending. If you take away money in ever increasing amounts, they will begin saving on the whole and reduce their spending.
Business (the supply side) sits on the opposite side of consumers in the economy. They provide the goods and services that consumers wish to consume. An essential component on the supply side is labor, which assists business in its efforts to meet consumer demand. However essential labor is in this process, it is expendable as its duration of employment on the whole is largely influenced by consumer spending. In other words, excess labor is not needed when there is insufficient demand. As stated before, in a condition where consumer demand continues to fall, businesses will continue to shed labor and unemployment will rise. Each unemployed person will create another unemployed person, because labor is also a consumer.
The fundamental rule in macroeconomics is that somebody’s spending is somebody’s income. We are often told that wages are nothing more than a cost and should wages rise, unemployment will result. Clearly, though, this faulty reasoning assumes that workers do not spend their paychecks. So, if wages are nothing more than a cost, then why in the world would anyone agree to work for any business? Such arguments are made to influence the public into accepting business as the supreme agent in the economy. By accepting such an idea, the public develops a dependency on business, viewing it as the “job creator” and so, the supply side can then use public support to suppress wages in order to increase profits. The truth is that wages contain both a cost and a demand element. Everyone is a consumer and that includes labor. Labor is paid for its service and in turn, labor then spends its paycheck buying goods and services. As a consumer, the paycheck that labor spends translates into the income of business, thus confirming the fundamental macroeconomic rule that somebody’s spending is somebody’s income. So then, knowing this we can reason correctly that if wages are low,
1. we cannot ensure that what is produced can be sold, since low wages means less available income to spend.
2. consumer spending will not result in job creation without assistance from a financial source.
The question then is, on the whole, how do we make up the difference so that we can insure that production is sold, output can increase and unemployment decrease?
Understanding Macroeconomic Financing of the Domestic Private Sector
There are three basic ways we can get “money” into the hands of consumers to maintain or increase aggregate demand:
1. Federal Spending
2. External Sector Financing
3. Bank Credit
2. External Sector Financing
3. Bank Credit
Let’s start with number one, federal spending. The US Government is the centerpiece in a modern monetary economy. It is the currency issuing and regulatory authority. In other words, the US Government issues the US dollar and regulates the economy via its taxation authority. Since today’s dollar is free-floating, non-convertible fiat, the supply of US dollars available to the US Government is always equal to infinity and the US Government’s taxation authority backs the US dollar. Of course, that taxation authority is not used to ensure the funding of any federal spending, but rather, to ensure that we continue using US dollars. Because the US Government lays a tax that is payable only in US dollars, all of us must obtain US dollars to pay that tax. Therefore, taxation creates a demand for US dollars and it is why we use US dollars. So, the US Government issues the US dollars that we use and the method of adding US dollars to the economy is called deficit spending.
Deficit spending is one way to get dollars into the hands of consumers and it is also stable. Whenever the US Government deficit spends it is adding more US dollars to both the domestic private sector (you and I) and to the external sector.
Deficit spending is one way to get dollars into the hands of consumers and it is also stable. Whenever the US Government deficit spends it is adding more US dollars to both the domestic private sector (you and I) and to the external sector.
The External Sector
The external sector, comprised of exports and imports, determines the flow of US dollars into and out of the US economy. If the US is importing more than it is exporting, as it has been doing for many years, then US dollars are flowing out of the US and into the rest of the world and foreign goods are flowing into the US from the rest of the world. In this case, we say that the external sector is in deficit. If, on the other hand, the US is exporting more than it imports, US dollars would be flowing into the US from the rest of the world and US goods flowing out of the US and into the rest of the world. In this case, we would say that the external sector is in surplus. The financial position of the external sector largely determines whether or not the federal government should be running deficits and how large those deficits need to be.
Generally speaking, it is possible for the external sector to finance consumer spending in the domestic private sector, if the US is exporting far more than it imports. If it were exporting more than importing, jobs would be created to meet the rest of the world’s demand for US goods and the US dollars flowing into the US from the rest of the world could “finance” consumer spending. But this financing is contingent upon being able to meet and then exceed the domestic private sector’s desire to net save. Therefore, the level of exports would have to be substantial. If the external sector cannot meet this desire, then a spending gap exists and the US Government must run deficits to fill the spending gap.
Given the fact that the US maintains a current account deficit (importing more than exporting), the external sector simply cannot finance the domestic private sector. Further, the current neoliberal environment of reducing federal deficits at all costs and low wage underemployment leaves us with a critical spending gap that must be filled in some way to ensure that what we produce can be sold to consumers and unemployment can drop.
Given the fact that the US maintains a current account deficit (importing more than exporting), the external sector simply cannot finance the domestic private sector. Further, the current neoliberal environment of reducing federal deficits at all costs and low wage underemployment leaves us with a critical spending gap that must be filled in some way to ensure that what we produce can be sold to consumers and unemployment can drop.
Bank Credit
Contrary to popular belief, banks do not issue US dollars, nor do they loan out US dollars from reserves. Bank lending is accomplished through credit money creation, which, quite simply, is an IOU exchange. When you approach a bank for a “loan”, the bank will first determine your creditworthiness. Each bank has its own standard and overall, what constitutes creditworthy is largely determined by the state of the economy. If the economy is booming, standards are relaxed and in a downturn, standards become restrictive. In other words, in an economic boom, consumers with lower credit scores and income generally find it easier to obtain loans and credit cards. In a downturn, consumers with lower credit scores and income generally find it harder to obtain loans and credit cards.
After you have been determined creditworthy, the bank will create a deposit for you. That deposit does not consist of US dollars. The deposit is nothing more than bank IOUs. In order to make the bank’s IOU become “money”, the bank denominates its IOU in the unit of account of whatever nation that bank is issuing the loan. In the US, the unit of account is the US dollar. Essentially, the bank “pegs” its IOU to the US Government’s currency, the US dollar and the bank’s IOU becomes acceptable as payment for goods and services and therefore acts as “money” in the private sector. Consumers then use bank credit to consume production (goods and services produced) and thus, bank credit ensures that when the external sector is in deficit and the federal deficit is being reduced, a condition of low wages can continue, because obviously whatever gap in consumption was created by a lack of federal deficit spending and low wages is now filled.
But it is important to remember that bank credit is not a US dollar and furthermore, for the privilege of using the bank’s IOU to purchase goods and services, the bank charges you a fee called interest. Not only must you pay back the principle, but also the interest. So then, we can now understand that credit creation results in private debt. In a low wage underemployment environment and in absence of federal deficit spending, private debt expansion can be used to fill a spending gap, but it is highly unstable, because clearly, consumers and businesses cannot take on endless amounts of private debt. Nevertheless, private debt is how we manage the US economy today. Rather than encouraging a more stable means of consumption of production through federal deficit spending and better wages, the dominant mainstream neoliberal opinion is to avoid federal deficits and to keep wages down, pushing private debt onto the population to ensure that what is produced gets sold. In 2009, Barack Obama demonstrated his support of neoliberal opinion by explaining that:
“…although there are a lot of Americans who understandably think that government money would be better spent going directly to families and businesses instead of banks, “Where is our bailout?,” they ask, the truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth.”
While it is true that credit expansion increases consumer spending and therefore, increases job creation, the truth is that credit expansion is an artificial stimulus that cannot be sustained without the assistance of federal deficits aimed at employment. The method is highly unstable and when consumers and business cannot take on any more private debt from credit expansion efforts, then in absence of federal deficit spending, consumer spending will contract, jobs will be lost and a downturn will occur.
The reason for the failure to recognize this danger lies in a faulty premise concerning the mainstream’s theory of banking operations; a theory where banks are assumed to be acting as “intermediaries”. The belief is that banks take customer deposits, build up reserves and then lend them out at interest. We know that no such thing occurs, because banks cannot and do not lend out reserves. In addition, it is also assumed incorrectly that the Federal Reserve controls the money supply.
A Brief Look at the Money Supply
To further dispel mainstream mythology, we need to look at what the money supply is and what determines it. The mainstream insists that the Federal Reserve controls the money supply, but this is false. The Federal Reserve, being a government agency, can control the price of money, but it has no control over the money supply. True, the Federal Reserve emits HPM (US dollars) however, as we understand from our discussion on bank credit, banks do not lend out reserves; banks issue IOUs denominated in US dollars, so the “money supply” is determined by demand for bank credit. As banks issue loans, the money supply expands. As consumers and businesses pay off their loans, the money supply shrinks. In layman’s terms, when bank IOUs are paid back, the “money” that was created is then destroyed. Bank transactions such as these are what we refer to as horizontal transactions.
At this point, when discussing banking operations, it is important to understand that only the US Government can add or destroy US dollars, which occurs through interactions between the government and non-government sectors and which we refer to as vertical transactions. Banks can shift reserves from one bank’s reserve account to the next, but they cannot add or reduce US dollars. Influencing the supply of actual US dollars requires action to be taken by the US Treasury or the Federal Reserve.
So, in summary, bank lending is the process of leveraging HPM (US dollars) created by vertical transactions in order to profit. Banks issue IOUs which are pegged to the US dollar and the money supply expands or shrinks based on demand for these bank IOUs (bank credit).
Understanding that today’s money supply is determined by demand for bank credit and that in absence of federal deficit spending, a demand for bank credit results in private debt, we now turn to questions concerning financial instability within the US economy.
A Brief Look at Financial Instability
"As the period over which the economy does well lengthens, two things become evident in board rooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever. After the event, it becomes apparent that the margins of safety built into debt structures were too great. As a result, over a period in which the economy does well, views about acceptable debt structure change. In the deal-making that goes on between banks, investment bankers, and businessmen, the acceptable amount of debt to use in financing various types of activity and positions increases. This increase in the weight of debt financing raises the market price of capital-assets and increases investment. As this continues the economy is transformed into a boom economy." – Hyman Minsky
Without going into enormous detail, I will explain the concept for the benefit of the uninitiated public in general terms. Minsky realized that when an economy is doing well, stability will lead to instability. Now then, how does that occur? It is realized that private debt is profitable and so, given the fact that everything is doing well, surely we can make the economy even better, along with profits.
Therefore, what once was deemed acceptable concerning private debt changes, standards relax and we push the envelope a bit further. We push and find that things are, in fact, doing even better, so we test the waters yet again, pushing the envelope further. As we continue pushing, an economic boom occurs and everyone thinks everything is just wonderful. However, the result is a move from a more productive investment environment to one of speculative investment. As the euphoria from speculation increases, instability then arises eventually ending, at some point, in a collapse.
So it is that we cycle between booms and downturns as speculation increases, fueling a booming economy and then the boom ends when the domestic private sector cannot take on any more debt. But the situation doesn’t stop with the downturn. We repeat the process over and over, each time relaxing standards to greater degrees until one day, a financial crisis, such as the recent Global Financial Crisis of 2008, occurs.
How We Manage the Economy Today
We have spent decades suppressing wages which are necessary to ensure production is sold, slashing federal deficits and relying on bank credit more and more for the consumption of production. We deregulate banks, making speculative investment the order of the day, allowing banks to create riskier and riskier products. In other words, we’ve been trying to create the illusion of a self-regulating free market, something which does not and cannot exist within the framework of a modern monetary economy where the federal government is the actual currency issuing and regulatory authority. By doing so, we’ve redistributed the national income to capital, increased the indebtedness of the population and destabilized the economy. Finally, in 2008 the bottom falls out. After the financial crisis occurs, the Federal Reserve goes into action, doing its job to ensure that the payments system doesn’t collapse. From the fiscal side, however, Congress and the President prevent the US Government from doing its job as a currency issuer which is deficit spending for the public purpose. In layman’s terms, that means deficit spending to create and maintain full employment. Rather than take the correct macroeconomic view, Congress and the President urge deficit spending to prop up banks, then afterwards, deficit reduction while leaving a huge millstone of private debt hanging around the neck of the populace. Furthermore, and I will repeat President Obama’s words again for clarity, Obama asks that you be willing to take on even more private debt for the sake of “economic growth”:
“…although there are a lot of Americans who understandably think that government money would be better spent going directly to families and businesses instead of banks, “Where is our bailout?,” they ask, the truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth.”
And so, we arrive at 2016 and we hear, “Under Obama, the economy has recovered, unemployment is at 5% and all is well.” Factually, the economy has never recovered. What has been hailed as the longest stretch of job growth in US history is actually the slowest recovery in US history. Since the crisis, there has been a bias towards low wage underemployment, which is now rampant. But above all, the federal deficit continues to be slashed in the face of an external sector deficit, and so once more, the so-called “job growth” in the US economy has been fueled in the most unstable and irresponsible manner possible.
As of May 11, 2016, the U6 unemployment rate remains high at 9.7%, the economy has stalled and the federal deficit is automatically rising as more people apply for unemployment and welfare benefits. Surely, there is a better way to manage the economy.
Correct Management of the Macroeconomy
We begin by recognizing that the US Government is the currency issuing and regulatory authority and as such, it is the centerpiece in the economy. No free market solutions can exist in this macro environment. Its central role and position of influence cannot be reduced or removed without serious consequences to the economy. We must, therefore, recognize and accept the following:
1. Today’s US dollar is free-floating, non-convertible fiat. Hence, the US Government’s supply of US dollars is always equal to infinity and gold standard rules do not apply.
2. Because the US Government’s supply of US dollars equals infinity, federal taxes are therefore not a source of revenue for the federal government as a currency issuing government does not require revenue to spend. All spending occurs prior to any taxation. The US Government can afford to buy anything that is for sale in US dollars.
3. There are three sectors in the US economy and the US Government is but one of the three. The condition of the external sector will help us determine whether or not a federal deficit is necessary. If there exists a current account deficit or the US maintains a small current account surplus, the US Government must run deficits.
4. Federal deficits that are too high can become inflationary, but federal deficits that are too low result in unemployment. Therefore, since it is the job of a currency issuing government to spend for and maintain full employment, as long as involuntary unemployment exists, it is evidence that the federal deficit is too small.
5. A federal deficit can become inflationary if that excess spending exceeds the real ability of the US economy to produce goods and services. Therefore, demand-pull inflation is not a concern until we reach a situation where all who are willing and able to work can find a job (full employment).
6. The US national debt is not an actual debt. The national debt is all US dollars issued by the US Government, from the founding of the nation to the present, that have not been taxed away. There is no unsustainable level of public debt for a currency issuing government like the US Government.
7. The US Government does not borrow to fund spending. Treasury bonds serve no real financing purpose today. The Federal Reserve could be ordered to maintain a zero interest rate policy and the US Treasury could stop issuing bonds altogether.
8. The Federal Reserve is not a private bank, nor is it pseudo-private. The Federal Reserve is a government agency independent “within” government. Shares in the Federal Reserve do not denote ownership, they denote membership in the system. Both the US Treasury and the Federal Reserve cooperate to make the monetary system function and thus, they are the Consolidated Federal Government.
9. Private banks are not intermediaries. They do not lend out reserves. The money multiplier is a myth. The purpose of reserves are to ensure that the payments system operates correctly. All bank lending is credit creation (bank IOUs denominated in US dollars).
10. Wages are not just a cost. Wages contain a demand element also and good wages are a stable means to ensure that what we produce can be sold to consumers.
Knowing these ten facts about the monetary system, let’s construct a more rational program of management of our economy based in macroeconomic reality.
[We will stop here for now.]
