Saturday, May 21, 2011

Sovereign Currency Rocks

What’s so special about a sovereign, floating rate currency? Until the mid 1990’s few bothered to appreciate its fundamental characteristics. The currency of a sovereign nation can have a profound and positive influence on the nation’s economy.
Our basis for understanding money and budgets is rooted in our knowledge of household, corporate, or state government budgeting as they use the currency of the land. We know that we must earn income or take out loans in order to spend. So it is thoroughly ingrained in our culture to think that federal spending and budgeting should be the same, but it is not. Such thinking is consistent with the time during which the value of the dollar was based on the fixed value of gold, and this thinking is reinforced by archaic rules that have not changed since we went off the monetary gold standard in 1971. One example is the debt limit, which is unnecessary for a sovereign, floating rate currency.
The federal government is the monopoly issuer of the currency, a fiat currency convertible not to gold but only to itself. Neither income in the form of taxes nor loans enable government spending. The government can and does create money out of thin air and spend without fiscal restraint, subject only to the capricious will of Congress.
Taxation, as explained in an earlier blog, is not necessary for the government to spend. It is a means of both reinforcing demand for the currency and avoiding inflation by reducing aggregate demand for private sector spending. It’s as simple as that even though it goes against most people’s thinking including that of most economists, pundits, and all of Congress.
Borrowing, also discussed in another blog, is the means by which the Fed controls the interest rate on interbank loans; and therefore, the rate for short-term treasuries. This is a choice that benefits the banks and bond holders. It would be possible to just pay interest on bank reserves, which has the advantage that reserves, unlike bonds, are not considered debt. The fact that the Fed sets the short-term bond rate explains why countries like ours, the United Kingdom, Australia, Canada, and Japan are not held hostage by the global bond market as are the countries in the European Monetary Union. For us, there is no risk of default on obligations denominated in our own currency absent political shenanigans.
In another previous blog, we tried to dispel the commonly held idea that deficits are bad and surpluses are good. While surpluses are desirable in household budgeting, history shows that national surpluses hinder household saving. Private saving is enabled by national budget deficits. It follows that metrics other than deficits should be used in managing the national budget.
Consider unemployment for a moment. If we monitor production capacity and utilization along with inflation, we might maintain higher employment rates. Currently, we plan on a consistent unemployment rate of 4% to 5% as a hedge against inflation. This is a terrible waste of productivity that holds back growth of our GDP. We might better look at the performance of the economy not an arbitrary budget deficit number. 
We might also look at taxes differently and argue, perhaps, that corporate taxes are not necessary except as an instrument of policy. Corporate sales are closely coupled to aggregate demand, which would be influenced by taxes on households. We can imagine flat rate income taxes, perhaps, in combination with consumption taxes. Taxes could be made much simpler when viewed in this different light.
It amazes me that conventional wisdom continually uses household budgeting as the model for national budgeting, and professional economists never mention the properties of a modern, sovereign currency. My conclusion is that pundits and politicians risk losing their credibility and livelihood if they stray from the wisdom of their communal brain. Perhaps Professor James Galbraith said it better almost a year ago.

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Many thanks to Duane for improvements to this blog.

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