A monetary sovereign government such as Australia’s does not need to balance its budget or borrow the currency it creates, provided total spending does not exceed the economy’s real productive capacity.
Governments of countries with monetary sovereignty, including Australia, do not have to balance their national budgets and do not need to borrow the currency they create.
Conventional (i.e. neoclassical) economics is presented to the public as a science. Like science, it has complicated mathematical models, but these do not necessarily make a science. They are tools that can be applied to a wide range of subjects, including gambling, linguistics, and traffic engineering.
The real basis of science is observation, either direct, or indirect via controlled experiments. To be useful, mathematical models and their underlying theoretical structure must be consistent with observation.
Neoclassical economists inform us that the Australian economy must have a balanced budget over the business cycle. Otherwise, they claim, the deficit will cause inflation and will also compete with private investment. Also, the cumulative effect of many deficits is a huge debt for future generations to service. Some suggest that the country could go bankrupt.
This conventional ‘wisdom’ is repeated endlessly by politicians, public servants and the mass media. However, none of these alleged disasters is necessarily true, although they may occur in particular cases due to poor government management.
The alleged inflation mechanism is contradicted by real data from ABS, Treasury and RBA. It shows that, for most years since Australia floated the dollar in 1983, budget deficits have been the norm – exceptions occurred under Hawke Labor, Howard Coalition, and Albanese Labor. There is no correlation between budget deficits and inflation, which only exceeded 6 per cent in 1985-1990 after floatation, in 2000 due to GST introduction, and in 2022-2023 following Covid. Real inflation, not transitory price increases, can originate from either the domestic private or public sectors, or from imports, from either the demand or supply side of the economy.
Budget deficits have also been the norm in the USA, New Zealand, Japan and on average across 40 advanced economies, without correlation with high inflation.
When hyperinflation does occur, it is driven primarily by other factors additional to ‘printing’ money. For example, in Zimbabwe these factors were the confiscation of farms owned by white colonialists, their subsequent management by local people without experience of large-scale agriculture, and the resulting constraint on supply.
However, the risk of inflation is a potential constraint on federal government spending if total (government plus non-government) spending exceeds the country’s economic capacity as determined by raw materials, labour force numbers and skills, infrastructure and industries. Then demand exceeds supply and inflation is likely.
The Reserve Bank’s principal method of attempting to reduce inflation is to increase interest rates to reduce spending by the private sector. This strikes access to the necessities of life of low-income earners – food, housing and healthcare – and drives unemployment. Its effectiveness is debateable (here and here). It’s a very weak response when inflation is due to interruption of supply chains because of war.
Support for this cruel, socially unjust method is based in part on the notion that a unique Non-Accelerating Inflation Rate of Unemployment (NAIRU) exists. This assumes a trade-off between inflation and unemployment, that when unemployment is above an arbitrarily chosen NAIRU value (say 4 per cent), then inflation should decelerate and vice versa. Empirical support for this method is poor.
We all understand that households, businesses, and state and local governments must balance their budgets. Expenditure must be balanced by income plus savings plus any borrowings or selling off of assets. If expenditure is higher, the debt burden increases and bankruptcy is a risk. How is the federal government different?
The difference is that the federal government is the currency issuer while the other entities are currency users.
To examine this further, we must understand the source of the federal government’s money. The answer from neoclassical economics is ‘taxation of course’, but this is incorrect and avoids answering the next question, ‘where does the tax money come from?’
Conventional economics has no answer apart from the vague idea that money somehow evolved in the community from barter, a notion that’s contradicted by historical and anthropological studies.
A better explanation is given by modern monetary (or money) theory (MMT): when monetary sovereign governments (defined below) spend, they create money. When they tax, they destroy money. Taxes are not revenue for such governments. Instead, taxes ensure that government money is accepted and used by the people. Taxes can also be used to discourage anti-social activities such as pollution, rectify inequalities in wealth and income, and control inflation.
Nowadays a monetary sovereign country has a national or federal government which issues a fully fiat currency, that is, a currency created and backed by government that is not convertible at a guaranteed fixed rate into any commodity, such as gold, or any foreign currency. It floats on the foreign exchange market. Furthermore, the currency issuer must not have significant net financial liabilities denominated in foreign currencies.
Monetary sovereign countries include Australia, Canada, China, Japan and the United States. The individual countries of the European Union are not monetary sovereign, and neither are Australia’s states and territories.
It’s misleading to consider a government deficit in a monetary sovereign country to be a debt in the conventional sense. It is just a surplus in the private sector. Conversely, a government surplus is a deficit in the private sector.
Contrary to the conventional notion that government deficits ‘crowd out’ private investment, they actually supply money for private investment and savings.
MMT argues that monetary sovereign governments have no constraints on spending except for inflation. When an economy has fully utilised all its resources, any increased spending will cause inflation. The government does not have to borrow the money it creates. It creates money directly by spending or indirectly by issuing bonds and selling them to the non-government sector.
MMT proponents posit that, when monetary sovereign governments issue bonds denominated in their own currencies, they are not borrowing in the conventional sense. The money used by the private sector to purchase the bonds has already been spent into circulation by the government, which issued the bonds. The bonds are a government liability, as is the currency.
Of course, if the federal government keeps borrowing its own money by issuing bonds, interest payments will eventually become so large that they become a burden on the economy. But the government does not need to issue bonds to spend.
Instead of issuing bonds, the government could spend directly through the central bank, the RBA in Australia. In terms of the risk of causing inflation, there is no difference between creating currency directly or indirectly via the creation of bonds.
Apart from creating money, other functions of government bonds are minor and can be provided by alternative means. For example, as government bonds are effectively transferable savings accounts at the central bank, they could be replaced with actual term deposits at the central bank.
The risk of inflation during periods of government deficit spending can be mitigated by targeted taxation and targeted spending to increase national economic capacity.
To conclude, both observation and theory show that governments with monetary sovereignty do not have to balance the national budget, provided total (government plus non-government) spending does not exceed national economic capacity. This understanding would assist planning for environmental protection and social justice.
Dr Mark Diesendorf was originally a physicist who expanded into interdisciplinary research on energy and sustainability. Previously he was Professor of Environmental Science and Founding Director of the Institute for Sustainable Futures, University of Technology Sydney. Currently he is Honorary Associate Professor in the Environment & Society Group in the School of Humanities & Languages, UNSW Sydney. Web: https://research.unsw.edu.au/people/associate-professor-mark-diesendorf. Mark is the lead author of ‘The Path to a Sustainable Civilisation: Technological, socioeconomic and political change’ (Palgrave Macmillan, 2023).