How governments spend money

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Both ordinary people and professional opinion-makers have had much to say about the Australian federal government’s decision to ‘fund’ the reconstruction of Queensland’s public infrastructure by levying a flood tax.

Less has been said regarding the government’s line that further ‘tough choices’ will be needed in the cause of fiscal discipline and sound public finance – most likely cuts to welfare expenditure.

At any rate, the commentary I’ve come across – from politicians, ‘market economists’, journalists, friends and baristas – suggests that few people have much idea what government spending actually involves: how it is done, by whom, etc.

In the case of non-professionals, this ignorance is understandable. Public discussion and explanation of the topic, by people who do know better, is usually misleading.

In most cases, this deception is deliberate.

Take the Australian government’s public position, as stated two weeks ago by Treasurer Wayne Swan in the Australian newspaper:

As the Prime Minister has said, borrowing to fund the public reconstruction would be the soft option. Instead, by applying some fiscal restraint now, we free up resources to make room for the recovery, so that it doesn’t add to pressure on our growing economy. That makes our plan to bring the budget back to surplus by 2012-13 the right one.

Our strategy has been backed by the Financial Times newspaper and international rating agencies such as Moody’s, which commended Australia’s strong fiscal discipline in dealing with the floods recovery. Fiscal responsibility is also about keeping our budget in a position where it can deal with surprises in the future. Getting back to surplus gives us the firepower to deal with future battles. During the global financial crisis, our strong balance sheet – built in part on difficult savings in our first budget – meant we were immediately able to respond to the crisis with a stimulus program that helped our economy weather the storm.

So, even while dealing with the reconstruction, the government isn’t losing sight of its broader policy objectives.

The suggestion is that the federal government, just like any private individual, is dependent on the financial system. It must fund its spending operations, ex ante, and to do so it must demonstrate its creditworthiness to the market.

This bears little connection to reality – in fact it has things backwards. The tax-and-spending activities of the federal government form the indispensable basis for the Australian financial system and for monetary circulation. That the reverse seems true is the result of determined efforts by a particular social group to mould the state to its purposes.

Let me show why.

Suppose the Australian government wants to appropriate some real resource (goods or labour). Let’s say it contracts Leighton Holdings to re-build port infrastructure damaged in Queensland’s floods.

Symbolically, this requires the government to issue a cheque drawn on the Official Public Account at the Reserve Bank. Leighton Holdings deposits the payment at its private bank, forming a liability for the banking system. In turn, that bank’s private account at the RBA is credited by a matching amount, forming a liability for the government.

Government expenditure thus occurs effectively by the crediting of accounts, i.e. increasing the reserves of the banking system. These bank reserves or ‘exchange-settlement funds’ form the basis for the private payments system. Banks and other deposit-taking institutions choose to hold reserves at some desired level of liquidity, in order to meet settlement obligations whenever they arise.

If government spending results in banks holding more reserves than they’d otherwise prefer, the overnight cash rate falls. Or suppose there are inadequate reserves, prompting more bids than offers for funds in the overnight interbank market. The cash rate will rise.

To prevent too much day-to-day fluctuation in bank reserves, and to maintain its target short-term interest rate, the central bank engages in open-market operations. It sells treasury securities to drain excess reserves, or buys government securities (short-term debt instruments or bonds) to inject reserves. The latter activity is known as quantitative easing.

Alternatively, reserves can be annulled through taxation.

When Leighton Holding’s tax liability falls due, it extinguishes the debt by drawing on its private bank account. This operation in turn credits the government’s account at the RBA, and drains exchange-settlement funds at the central bank.

Taxation is thus a reduction of the government’s outstanding liabilities. A government deficit, on the other hand – an excess of spending over receipts – increases the financial assets of the rentier class.

Let’s pause a minute to consider how this intersectoral flow of funds works in the present context.

As a simple matter of accounting, in any period the savings of the private sector must balance state borrowing. In the period since 2007, Australian public-sector deficits have been the flipside to private deleveraging and the current-account deficit. Households and firms cut their rates of borrowing and retired outstanding debt. With falling tax revenues and increased unemployment benefits, the government became the borrower of last resort.

Now the state, to whom debt was offloaded, seeks itself to cut expenditure and start saving (nowadays known as ‘fiscal consolidation’).

But from where will the corresponding borrowing arise? Firms show no sign of borrowing on a large scale to finance investment. The financial sector is of course a net lender, and it’s not those assets the government wishes to see run down. With no hope of a surplus with the rest of the world, this leaves only one party on which higher sectoral borrowing can be pushed.

The aim of government policy is clearly enough to increase household debt, firstly through cuts to public-sector wages and employment. Enough new unemployment will reduce pension-fund contributions; these institutional funds hold a large stock of government liabilities. Unemployed workers will also be forced to run down their savings and enter into debt.

This strategy lies behind the social convulsions presently wracking the United States, and indeed much of the northern hemisphere.

The Labor-Greens state government in Tasmania has already announced plans to reduce public-sector labour costs by 10 percent, an amount equivalent to the wages of 2300 employees.

Beneath the symbolic activities of government expenditure and taxation lies a real, unilateral transfer of wealth.

In levying a tax, the state symbolically asserts its primordial right to command a part of society’s labour time, and thereby claim a portion of the social product.

Taxation by modern states commutes the citizen’s ancient obligation to perform labour service or pay in-kind tribute to the state. Nowadays governments such as those of Australia, the US, UK, Japan or Canada (but not those of the Eurozone countries) have the sovereign power to impose and enforce periodic tax obligations denominated in a particular national currency, surrender of which is the only legal means of discharging liabilities.

This creates recurrent demand for the state currency, which otherwise possesses no inherent property or substance by which value could be imputed to it. Henceforth it is needed to settle debts; in turn, state spending creates liquidity.

When it taxes private agents such a government merely collects its own tokens. These tokens have purchasing power, and serve as unit of account, because the government undertakes to accept them in settlement of tax debts. These certificates are transferrable and, through commodity exchange, they circulate. Thus the sovereign’s power to command labour is delegated to all who hold money.

Now let’s return to our example case, based on the flood tax.

Suppose the Australian government uses the labour time of Leighton Holding workers and the resources of that company to rebuild a damaged port, yet fails to balance that with a symbolic reflux (i.e. tax or debt securities) of money equal to the value of those resources.

In that case the unit of account, the Australian dollar, will tend to fall in purchasing power. Injecting more money into the system than is taken out in tax will lead to inflation.

This is what lies behind the present government’s obsession with ‘fiscal restraint’.

When questions of public finance arise, the over-riding concern is to combat inflation. It lurks behind all public discourse, spanning the entire spectrum of respectable political and theoretical opinion: from a hard-core right that speaks of “crowding out” to the claim of putative “progressives” that the government budget should be balanced over the course of the business cycle.

Why this fixation on price stability?

The maturation of capitalist economies has propelled to the top of the social hierarchy (in Australian and elsewhere) a thin class of rentiers. The income of these agents is derived largely from dividends, interest payments, capital gains and exorbitant executive salaries (including bonuses and stock options). Their economic activity is accordingly concentrated in the finance sector. Their chief concern is that the liabilities of their debtors must not be inflated away.

To the growth in the relative weight of the financial industry within the economy as a whole, corresponds an increase in the strength of Treasury and Finance ministries compared to other government departments and agencies. Executive public-service personnel in these departments, along with the central banks, share a thin membrane with the private banking and finance industries, across which constant two-way passage secures a commonality of background, ideological outlook, labour-market conditions and policy perspective.

Special-purpose ministries continue to exist for each diverse area of state responsibility (aged care, disability support, education, immigration, health, regional development, housing, environmental policy, welfare, telecommunications etc.). But the formation of government policy across this entire breadth is increasingly controlled by the core finance-linked departments, together with the central bank.

In Australia, the Productivity Commission (part of the Treasury Department), as part of its policy-advice remit, constantly oversees and assesses the delivery of all government services and programmes.

To the rentier class thus devolves control over the state apparatus, and consequently over the fundamental social trajectory, of Australia as of every advanced capitalist country.

The priorities of the financial industry – price stability, free capital mobility, wage restraint – are now shared by all state personnel, parliamentary parties, central organs and peripheral institutions (e.g. media and academia).

These class-based goals are codified in the statutory objectives of bodies such as the Reserve Bank – which, starting from the 1990s, defined price stability as the ‘ultimate objective of monetary policy and indeed of economic policy as a whole’. (The RBA’s postwar full-employment objective, as Kalecki would have anticipated, has been sidelined).

Any public figure who questions this unholy consensus, sincerely or otherwise, is immediately subject to withering ridicule and slander, prompting either silence, recantation or career oblivion.

The resulting state conforms almost exactly to Hayek’s ‘model constitution’, in which certain matters (e.g. those pertaining to property rights) were to be exempted from the control of popularly-elected legislatures.

When it came to any broad-suffrage representative assembly, said Hayek, ‘power ought always to be limited in extent and scope, namely confined to the administration of a sharply circumscribed range of means entrusted to its care.’ Authority over matters such as taxation, the ‘framework for a functioning competitive market and the law of corporations’ should be reserved for ‘a select group of highly competent persons’, not very numerous, aged between 45 and 60, ‘who already had proved themselves in the ordinary business of life’, elected perhaps by regionally-appointed delegates of ‘relatively mature age’, then serving ‘for fairly long periods, such as fifteen years, so that they would not have to be concerned about being re-elected… nor forced to return to earning a living in the market.’

Under Australia’s Westminster system, Commonwealth and state ministers are supposed to be responsible to their respective parliaments. But increasingly executive power is wielded by “kitchen cabinets”, membership of which does not require the confidence of representative bodies.

The South Australian Labor government recently included a mining executive and a Catholic monsignor in its executive committee of cabinet; the New South Wales Labor government followed this unprecedented action by appointing two business figures, without parliamentary seats, to its own executive committee.

At the federal level, Prime Ministers too have assembled ad hoc coteries and advisory ’roundtables’, allowing business leaders to participate in decisionmaking beyond the reach of Parliament.

The authoritarian nature of all this is explicit. Institutional changes have produced government not merely on behalf – but now at the direct behest – of the financial elite.

The rise in social power of the financial elite is what lies behind that growth in authority of the executive branch (ministers as well as top levels of the civil bureaucracy), unchecked by legislative or judicial scrutiny, that is obvious in Australia as elsewhere.

Update: Today’s Australian Financial Review reports on the deal secretly negotiated in July 2010 by the new Prime Minister, her Treasurer and Resources Minister with mining executives from BHP Billiton, Rio Tinto and Xstrata. By scrapping the Resource Super Profits Tax, the paper estimates the Gillard government agreed to forego over $100 billion in federal revenue over the next decade. This massive figure is based on mineral price and volume assumptions obtained from Treasury. The Australian net public debt is currently around $80 billion.

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