Why the Federal Budget is Not Like a Household Budget

Open Modal

Share this on

Open Modal

Print content

Reading Time: 5 minutes
Help keep family & friends informed by sharing this article

By Warwick Smith, Economic Reform Australia Review, Vol. 7, No 2., March-April 2015

Treasurer Joe Hockey is experiencing difficult times. Deteriorating terms of trade and an uncooperative senate mean that he cannot deliver the surplus when he said he would and he cannot continue to cut government expenditure without risking a recession.

I have some comforting news for Joe Hockey: the importance of the whole deficit/surplus thing has been greatly exaggerated – with a lot of help from Joe himself of course. The focus on deficits and surpluses distracts us from what’s really important in the macro economy.

Hockey and Abbott are very fond of using household analogies when discussing government finances – Hockey again compared Australia’s economy to a household budget in his Mid-Year Economic and Fiscal Outlook. However, a government that is sovereign with respect to its own fiat currency bears no resemblance at all to a household. Such a government creates the money we all use, either physically on a printing press or, more importantly, electronically in the accounts of financial institutions.

Licence to Print Money

Everyone understands that governments can create money. Most people also understand that governments don’t just create all the money they need for all the things people want because it would cause inflation. Inflation is the devaluation of money. If you have a really good season for growing apples and there is a glut, the price of apples falls. Similarly, if you have a glut of money, the price of money falls. That’s inflation.

So, here lies the key insight. Inflation is the limiting factor for government expenditure, not taxes or borrowing. A government that can create money doesn’t need your money from taxation or from borrowing in order to spend. There is no limit to how much money a sovereign government can spend, but if government spending plus private spending exceeds the productive capacity of the economy then you get inflation.

The real calculation faced by government should not be about how much money the government has – it has an infinite amount. The calculation should be about the capacity of the economy to absorb government spending without driving inflation.

Seeking a balanced budget and automatically borrowing any deficit spending (as we currently do) is an effective but unsophisticated way of ensuring government spending doesn’t cause runaway inflation. Taxes and government borrowing remove money from the private sector, creating space for government spending (which injects money into the private sector). Remember, the government does not have to borrow or tax in order to finance spending because they can create money.

The slowing Australian economy combined with the dramatic fall in global oil prices mean that inflation is set to fall and unemployment is rising. This is precisely the kind of environment into which the federal government could spend without borrowing (i.e., create money). Times like these represent opportunities for the government to finance productivity improving infrastructure and provide much needed services for nothing. I know it sounds too good to be true but this is the reality of a fiscally sovereign government.

The Government Could Spend More

Can the government just spend as much as it wants on whatever it wants? Of course not, the result would be out-of-control inflation. Can it spend a lot more than it currently is without substantial negative consequences? Absolutely.

The much discussed “quantitative easing“ in the US, UK and EU is an example of this kind of spending (though very poorly targeted). The US Federal Reserve has created trillions of dollars out of thin air and used it to buy risky financial assets and government bonds in order to take the risk off the balance sheets of financial institutions and improve their supply of money. The money was created with keystrokes on a computer which simply credit the accounts that these financial institutions hold with the Federal Reserve. There has been no runaway inflationary impact of this “printing” of trillions of dollars.

This reality of fiat currency is very difficult for many people to grasp but it’s not quite the magic pudding that perhaps it appears to be. When a government creates money, it isn’t creating value from nothing. The value lies in the human and capital resources that are underutilised in the economy. The money created by the government is simply the lubricant needed to mobilise these resources.

So, productive government spending is limited by the capacity of the economy to provide the goods and services that the government wants to purchase plus the goods and services the non-government sector wants to purchase. During economic downturns, and especially in recessions, there is spare capacity in the economy which can be employed by government. It’s possible, with this in mind, to quite easily return to the post-war days of genuine full employment even during an economic downturn.

Some Basic Realities

Until people understand the basic realities of monetary economics we cannot have a meaningful discussion of government finances.

Rather than worrying about deficits and surpluses we should be asking whether the economy would benefit from greater or lesser government expenditure or taxation. This calculation balances unemployment, spare capacity, and the need for infrastructure and services against inflation risk. It’s a complex calculation but the underlying principles are pretty straightforward.

Let me just restate for emphasis: the need for balanced federal budgets is a myth. Like many myths, it does have some factual historical origins.

Back when currencies were backed by gold it was possible for governments to go broke. Because modern currencies are not backed by anything material, sovereign governments cannot run out of money and can never be insolvent in their own currency. Somehow, mainstream political thinking hasn’t kept up with the dramatic changes in the monetary system that occurred more than 40 years ago.

The first of our politicians to really understand this and to communicate it effectively to the public will have at their disposal the tools to completely reshape our economy for the better. I know politicians can be slow off the mark but 40 years is long enough. It’s time they caught up.

Warwick Smith is a research economist at the University of Melbourne and is a freelance writer.

Our Comment

Perhaps from his position between that rock and a hard place, Joe Hockey’s perspective will bring him fresh insight into the opportunity that crisis so often generates. He may be forced to shift focus from “the deficit surplus thing,” which is a distraction, to the “reality of fiat currency.” (Fiat currency: money that has no intrinsic value but has exchange value because it is generally accepted. Modern money is fiat money.)

Household analogies are equally popular with Canadian governments, exploiting unwary taxpayers, preying on their limited understanding of the “reality of a fiscally sovereign government.

That the government does not have to borrow or tax in order to finance spending because they can create money – yet do – is directly related to what is really at issue. That is, should the system’s priority be private profit, or the common good?

Alas! That the truth sounds too good to be true, makes it all too easy to discredit it.

The inflation argument against government-created money has been another important feature of neoliberal propaganda. It is not who creates the money that causes inflation – indeed, nothing is more inflationary than high interest rates, the solution favoured by private banks to fight inflation!

Inflation determines the limit to how much money a sovereign can spend. The productive capacity of the economy is the regulator.

As Graham Towers, first governor of the Bank of Canada confirmed: “Anything physically possible and desirable can be made financially possible.”

Why wait for a slowing economy to exercise fiscal sovereignty? Why not avoid a slowing economy by investing control over the nation’s currency and credit in the nation’s government, “as its most conspicuous and sacred responsibility”? (Prime Minister Mackenzie King) This could end the destructive boom/bust pattern of the present system, and has been historically demonstrated to be a viable practice.

If, without causing inflation, governments can create trillions of dollars out of thin air to bail out failed financial institutions after their irresponsible pursuit of private profit, why shouldn’t they create money to promote the common good, instead?

The proof of the “pudding” has been demonstrated in Canada and other countries. Why should money – which was originally designed as a means to an end – to facilitate the exchange of goods and services essential to society, be privatized, and allowed to become an end in itself?

We need to rethink full employment. Could the fact that mainstream political thinking has promoted the conversion of money into a cancerous medium of power account for the “somehow”?


Share Now

Add a Comment

Your email address will not be published. Required fields are marked *

Stay Informed,
Join Our Mailing List.
Its Free.

Your Information is safe: Privacy Policy

Support Comer

Your donations will help fund our research, education, and outreach activities as well as help cover our expenses.

Related Articles:

Stay Informed, Join Our Mailing List. Its Free.

Your Information is safe: Privacy Policy

Join our Mailing List to stay informed