Why The Federal Budget Is Not Like A Household Budget

This government is fond of comparing the economy to a household budget -- but there is one really major difference.

Picture: Getty Images/James Alcock

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.The Conversation

Warwick Smith is Research economist at University of Melbourne.

This article was originally published on The Conversation. Read the original article.


Comments

    Great article. Didn't expect to see it on here tho. Nice surprise.

    I think this every time they say there is no money for education, education should just be aloud a blank cheque endorsed by Australia

      +1 Need better English teaching. See above ;-)

      Unfortunately the benefits are hard to quantify for close minded politicians, "Surely smart people will always go to uni and earn more money", "Cream of the crop", "I paid for my own education" etc.
      As with medicine, "More people will go private", "The poor aren't paying for themselves, why should they get these benefits", etc.
      And here is a sentence, with fragments, a spelling misteak, and no full stop, just for hopoz

    And then I urge you to look at Zimbabwe when you think "printing" money or blank cheques or a few strokes on a keybord is going to solve your economic woes.
    It is a balancing act for one and Australia has an obese government. Go figure it out.

      I urge you, sir, to find out what the real problems with Zimbabwe were.

      Start here; http://bilbo.economicoutlook.net/blog/?p=3773

      It is a balancing act for one and Australia has an obese government. Go figure it out.

      Measured how ?

      Australia has one of the lowest tax takes in the OECD.

        Please cite your source.

        With a 10% consumption tax, and most working-class citizens on at least a 32.5% tax rate, plus 1.5% "medicare levy" (ie. 34% tax) that gives an effective tax rate of 44%.

        Surely that can't be typical of an OECD country.

          Note he said tax *takes* not tax *rates*.

          Here's a source: http://www.treasury.gov.au/Policy-Topics/Taxation/Pocket-Guide-to-the-Australian-Tax-System/Pocket-Guide-to-the-Australian-Tax-System/Part-1

            They related though, everyone thinks companies hold up taxation in Australia. They don't individuals pay way, way more tax. Companies could afford to be taxed more.

    Thank you for running such an important article, very informative. This knowledge really does need to be understood by more Australians. I'm sure a more than a few voters were swayed by the promise of a return to a surplus budget, we need to move the conversation...

    Good article. Didn't know you did this sort of thing. Keep it up.

    The govt doesn't use these analogies for the super intelligent lifehacker readers who know better... it's for the vast majority of stupid people that need something simple

      I don't think that's the case. I think that the household budget analogy is used because the required action in the analogy is what the current government wants to do. If the intention was to actually explain the budget to 'stupid' people, then the government would at least try to make sure that the analogy is actually vaguely analogous.

    Warwick Smith appears to be a chartalist and a proponent of Modern Money theory. I think it should be noted that this is a heterodox economic theory. While that of course doesn't mean that it is wrong (I haven't thought about MMT in about 5 years so I can't really remember what conclusion I came to), it does mean that it is not the consensus view of academic economists.

    The headline point (that government budgets don't operate like household budgets) is something that is absolutely compatible with the mainstream consensus and is something that should be strongly propagated.

    excellent article

    I think it's nieve to think that most people are okay with the idea that money is basically a shared fiction. The extent to which they are aware of it, they are in denial.

    What the article fails to mention is that most money is actually created by the banks. And by most I mean about 90%. If most people are uneasy with the government creating money out of thin air, they are horrified by the idea that banks create many times more money also out of thin air (or computer bits).

    And that's why we can't have a sensible discussion about it. The current government policy of issuing income tax receipts only muddies the waters even further by perpetuating the lie that government spending is funded by taxation, which it isn't.
    Taxation is necessary because it takes some of the money created by the banks back out of the system. It is a release valve that keeps inflation under control.

    Call me old fashion I like the old gold system better.

    I might be wrong but living under constant debt is not good, who collects the interest on these government bonds? All this debt needs to be paid at some stage.

    The world economy is so thinly geared and stretched.

      A sovereign country with a fiat currency can never default on debts that are issued in that currency (unless the government of the day chooses to). It's basically corporate welfare as there is no intrinsic need to issue debt. That's why it doesn't matter that the US has so much debt in China - it will never default, as the debt is in USD.

      The only limit is the real resources available in the country (manpower, crops, manufacturing etc).

      That's an important difference between Australia and Greece or Italy - they surrendered their sovereignity by choosing to go with the Euro which is the number one cause of their continued troubles today.

    Thanks for this article. This is the kind of thing we should have been taught in high school.

    Someone correct me here, but when we say the Government creates money - isn't it is actually the Reserve Bank creating the new money for the Government (ignoring the actual process) and the Government still has to pay this back to the Reserve Bank..?

    As others have said, it's great to see this kind of article on Lifehacker.

    But note that it has been reprinted, with permission, from The Conversation, another great website that produces many great discussion articles of this nature.

    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.

    But Greece and others...........surely he doesn't think they were fine to keep going as they were?
    I know they couldn't print some more Euros, but I am weary of you way of economics, which is just way of looking at it.

      Greece does not have a soveriegn currency. It has to beg money off the Eurozone. Biiiig difference.

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