BEE Partner, South Africa Economy Watch

The government budget tends to move counter-cyclically. In a slump, incomes will be reduced and spending curtailed, so tax collections will fall, but welfare and related spending to support the unemployed will tend to rise. Other government budget items are likely to be unaffected. Hence, the overall effect will be to throw the budget into deficit. By contrast, in a boom, tax collections will rise and welfare spending will tend to decline, so a surplus will tend to emerge. In short, in an economy with demand-based cyclical fluctuations, the central government budget will tend to move in a counter-cyclical fashion.

Now consider the monetary implications of deficits and surpluses. A deficit arises when the government spends more than it receives in taxes; this means a net increase in money in the system. Such money will appear as excess reserves in the banking system. If allowed to remain, it will drive down interest rates. Looked at another way, it will drive up security prices. A surplus is just the opposite; it arises when the government spends less than it takes in, and it creates a reserve deficiency, tending to force interest rates up.

In order to maintain its desired level of interest rates, the treasury must issue bonds to absorb funds, or buy bonds to provide funds. Government borrowing, in other words, serves the purpose of keeping interest rates at the level the central bank and/or the Treasury think appropriate.

In short, when a modern government spends, it always creates the money to do so; the central bank creates a balance for the government, which givesthe central bank bonds in exchange.³⁶ That is, money is created when the government spends, drawing on its balances with the Fed, and its spending appears as receipts in the accounts of businesses and households, who, in turn, re-spend these funds. The money will remain in the banking system until it is drained out by taxes. Note that the government does not ‘raise money‘ through taxation. Taxation ensures that the government’s money will be accepted. When taxes are paid, the government’s balance with the central bank is reduced; that is, the money is destroyed. A check in payment of taxes, when cleared, reduces the government’s balance at the central bank; it therefore reduces the money supply.

The Government Budget, Contrasting the Old and New

Taxes in a craft economy raise money. The state cannot issue new paper without adequate backing. Given a reserve ratio, its ability to issue is limited by its reserves. So to spend, it must have money on hand; either it spends out of its reserves, which requires calling in paper or getting away with a lower reserve ratio, or it must raise the money by collecting taxes. By contrast, in a mass production system, taxes are not needed to raise money. The government creates money as it spends; when it collects taxes, it reduces the amount of money in circulation. Money collected in taxes is destroyed — paper money is burned, and checks that pay taxes reduce the government’s liabilities, which are part of the money supply.

Financial markets in a craft economy serve the purpose of raising money for investment, but that is not their chief purpose in the modern era. In the earlier system, bonds were issued to mop up savings and assemble funds for large-scale long-term investment. Savings — supply of funds — were a function of the rate of interest; higher interest rates tended to call forth more savings. Investment — demand for funds — would be greater the lower the rate of interest, and would be smaller the higher the rate. Hence supply and demand for loanable funds tended to determine the bond rate of interest. By contrast in modern financial markets, stocks do not tend to raise money; buy-backs tend to equal or outweigh new issues. Bonds are often issued to finance takeovers and mergers. And this is the chief function of financial markets under mass production — they become the markets for corporate control.

Government spending in a craft economy requires having money on hand. The Government is constrained. It cannot create money; it must raise funds by collecting taxes or by borrowing. (Obviously, all through history, governments have sought — with a good deal of success — to evade or loosen this constraint. Debasing the coinage and issuing non-convertible paper are perhaps the best- known methods.) But borrowing means issuing bonds; it is, or may be, interpreted as a tacit admission that the government cannot effectively collect the money it needs in taxes. If that is so, how will it be able to service and eventually repay the bonds? By contrast, in a mass production system, the government creates the money it needs for its spending. Taxes are collected to ensure that the money is acceptable. Bonds are rolled over, and may be perpetual; they never have to be repaid. The government is constrained in its spending not by the monetary system, nor by the ability to collect taxes, but by the real capacities of the economy. If the economy is operating at less than full capacity, then the constraint is not binding. However, another constraint, internal to the government itself, may be important: What the government can do at any one time depends on its capacity to effectively plan and supervise its activities, and this ability — dependent on the available managerial skills — will normally be limited. Moreover, expanding this ability will itself be an activity requiring planning and supervision, and so can only be carried out by drawing on the very set of skills that are in short supply.

Deficits, then, have a very different meaning in the two systems. In the craft economy, deficits are a burden. They are likely to drive prices up, they will certainly tend to drive up interest rates, and they may damage the credit of the government. By contrast, in a mass production economy, deficits are merely a residual, albeit when they have emerged ‘automatically,’ they are a residual with an important function: to stimulate the economy in a time of recession. Deficits do imply an increase in so-called ‘high-powered’ money that will have to be offset if interest rates are not driven down. And they may over the long term lead to undesirable effects on income distribution and on the division of output between consumption and investment, although this depends as much on interest rates, and especially on the i/g relationship, as it does on the deficit itself.

The new monetary system is without an anchor. So nothing supports the value of money, which is to say prices are not subject to any constraint. Money has only conventional value, so if the conventions on pricing change, there is nothing to _prevent inflation. Pressures of demand might lead to inflation and, on the other hand, inflation might be controlled by reducing demand. But at the same time, the size of government has risen dramatically, and the government budget tends to move counter-cyclically. This provides an automatic stabilizer for output and employment. But if the Phillips Curve exists, it would tend to exacerbate inflationary pressures.

And that is the way it has been seen: the government’s stimulus to the economy is believed to promote inflation. Unemployment and inflation are thought to move inversely; the higher unemployment (the weaker is aggregate demand), the weaker will be the inflationary pressures. On the other hand, the lower unemployment, that is, the stronger demand, the more dangerous the tendencies to inflation. This is the central implication of the Phillips Curve, the much disputed basis for the anti-inflationary policies of the last half-century.

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