Sunday, 23 January 2011

Describing the Spending Cycle

It's always important to remember that the economy is a cycle like the carbon cycle, or the water cycle. Everything moves in a circle. Spending becomes income, income becomes spending.

You can start a description of the water cycle with rainfall if you wish. And it is very useful since you can show the water coming out of the clouds into rivers and rushing down to the sea. That is after all the functional part and reflects our personal experience.  We notice the rain first (and if you're British you then talk about it endlessly).

However a moment's reflection reveals an important question: how did the water get into the air in the first place? Then you realise that although the 'rainfall first' model reflects our experience of the system, the more accurate starting place in the cycle is evaporation since without that there can be no water in the air. That switch of viewpoint then leads you to realise that evaporation happens throughout the cycle due to the action of the Sun, and suddenly you have a new insight into the system.

So the system didn't change, and the 'rainfall first' description is correct as far as it goes. But by switching your focus to 'evaporation' you describe the system from a different viewpoint - which lead to a new insight that was clouded (sorry!) by the original position.

So it is the same with government expenditure in a nation. You could start with borrowing, follow it through spending and onto taxation. Then you would start using terms like 'debt' and 'deficit' and worry about whether tax levels are high enough because the numbers don't add up.

Yet if you are in a nation with a free floating exchange rate and its own non-convertible currency a moment's reflection would reveal two questions.

Firstly since the government is borrowing in its own currency, how did that currency end up in somebody else's hands so it can be borrowed?

Secondly why is the government issuing 'corporate bonds' to borrow rather than just going to its bank and asking for a loan like everybody else does?

To answer these questions simply requires that you start your description further around the spending cycle. For currency to get into the private sector the government has to spend it first. Where does that come from? A loan from the government's bank - the central bank.

So the government has a rolling loan facility at the central bank. The central bank extends the loan when requested and creates the corresponding deposit and because it is the central bank for a non-convertible sovereign currency that deposit is currency. (The central bank doesn't have to fund that loan with gold or anything else). The government then spends - hopefully on something counter-cyclical and/or advancing public purpose. The spending bounces around creating transactions and taxation. The taxation comes back to the government and reduces the size of its loan.

And fiscally that is the end of the matter. That is the cycle. Nothing else is required. The government is obviously good for the loan because, well, its the government.

However the government also decides as a matter of policy to offer higher rates of interest to long term savers in its currency. It then has an office of government issue savings deposit bonds to holders of currency who want to save. The currency retrieved from this operation reduces the government's loan at the central bank. In this way the government 'borrows' back the currency it originally spent.

It's the same system, and again the 'borrowing' description is one viewpoint. However a different viewpoint focusing on the spending first leads to fresh insights into the system and a whole load of new policy possibilities.

And once you see it, the clouds part.