Discussion: Auerback-Berzins-Hansen

Discussion about the article:

Morten Hansen, Budget constraints | IR, 2010.05.27 | View the article

2010.05.28 | Marshall Auerback

Dear Mr. Hansen and IR Readers:

An acquaintance from Daugavpils sent me the article from Mr. Morten Hansen in Latvia. While I have never heard of him previously, I will be happy to rejoin his remarks on my articles. First, I wish to comment on the last points made in his article. He ends his article with a red herring designed to distract the readers attention, presumably, from the economic arguments at hand. Apparently, he wishes to engage this terrain, because he seems, to my mind, weaker on economics. He mentions figures in Latvian politics which I have never met, nor with whose policies I am acquainted. It looks to be a clumsy attempt at deploying guilt by association that was common under the tenure of the “Josephs’” (Stalin and McCarthy). While I was invited to speak at, what I have been told was an opposition party’s economic conference, I am indeed happy to speak with anyone in Latvia or any other place, for that matter, on economic policy. Now, onto matters of substance. My work has been criticized before by those disagreeing with my economic policy suggestions by linking them to the Weimar/Zimbabwe cases. This is certainly the most simple charge to lodge against my work, but hardly the best or most original execution I have seen of this obvious strategy. Let’s take these points in turn, since Mr. Hansen’s grasp of economic history seems a bit thin:

If we think about the Weimar Republic for a moment, the problems for them began long before the hyperinflation, which really went off in 1923. Following World War I with the reparations payments required under the Versailles Treaty squeezed the German government so badly that they eventually defaulted. The Treaty was just a bloody-minded pay-back by the victors of the war and brought so much subsequent grief to the World in the 1939-1945 War that you wonder what was going on in their heads at Versailles.

Anyway, you will recall that the French and Belgian armies then retaliated after the German default and took over the industrial area of the Ruhr – Germany’s mining and manufacturing heartland. The Germans, in turn, stopped work and production ground to a halt. The Germans kept paying the workers in local currency despite limited production being possible and you can imagine that nominal demand quickly started to rise relative to real output which was grinding to a halt. The crunch came when the export trade stalled and the only way the German Government could keep paying their treaty obligations etc. was to keep spending. Inflation followed.

But think carefully about the causality here – it was not a normal situation at all where a sovereign government was trying to finance the saving desire of the non-government sector and keep employment and output levels high.

Regarding Zimbabwe, the problems came after 2000 when Mugabe introduced land reforms to speed up the process of equality. It is a vexed issue really – the reaction to the stark inequality was understandable but not very sensible in terms of maintaining an economy that could continue to grow and produce at reasonably high levels of output and employment.

The revolutionary fighters that gained Zimbabwe’s freedom from their colonial masters were allowed to just take over productive, white-owned commercial farms which had hitherto fed the population and was the largest employer. So the land reforms were in my view not well implemented but understandably motivated.

Like the allies after Versailles, you sometimes do not get what you wish for. The whites in Zimbabwe had always been reluctant to share with the majority blacks and ultimately reaped the nasty harvest they sowed.

From an economic perspective though the farm take over and collapse of food production was catastrophic.

Unemployment rose to 80 per cent or more and many of those employed scratch around for a part-time living.

So the land reforms represented the first big contraction in potential output. A rapid demand contraction was required but impossible to implement politically given that 45 per cent of the food output capacity was destroyed.

The situation then compounded as other infrastructure was trashed and the constraints flowed through the supply-chain. For example, the National Railways of Zimbabwe (NRZ) has decayed to the point where capacity to transport its mining export output has fallen substantially. In 2007, there was a 57 percent decline in export mineral shipments.

Manufacturing was also roped into the malaise. The Confederation of Zimbabwe Industries (CZI) publishes various statistics which report on manufacturing capacity and performance. Manufacturing output fell by 29 per cent in 2005, 18 per cent in 2006 and 28 per cent in 2007. In 2007, only 18.9 per cent of Zimbabwe’s industrial capacity was being used. This reflected a range of things including raw material shortages. But overall, the manufacturers blamed the central bank for stalling their access to foreign exchange which is needed to buy imported raw materials etc.

The Reserve Bank of Zimbabwe is using foreign reserves to import food. So you see the causality chain – trash your domestic food supply and then have to rely on imported food, which in turn, squeezes importers of raw materials who cannot get access to foreign exchange. So not only has the agricultural capacity been destroyed, what manufacturing capacity the economy had is being barely utilised.

Further, goods and services have also been prevented from flowing in via imports because many importers abandon goods at the border when they are hit by exorbitant import duties.

Taken together, the collapse of production has seen the unemployment rate rise to 80 per cent or more. The rising unemployment has further choked any household income growth and aggregate demand has fallen even further.

As a consequence, GDP growth has been contracting at around 7 or 8 per cent per year and the economy’s potential capacity level has been falling dramatically as investment dries up.

Further, the response of the government to buy political favours by increasing its net spending without adding to productive capacity was always going to generate inflation and then hyperinflation.

But while the hyperinflation was almost inevitable it provides no intrinsic case against a government that is sovereign in its own currency and who runs permanent deficits to pursue full employment – under the guidelines specified above – responsible fiscal management.

When you so comprehensively mismanage the supply side of your economy as the Zimbabweans did the only way to avoid inflation is to severely contract real spending to match the new lower capacity. More people would have starved and died than already have if the Government had have cut back that severely.

But this disaster has nothing much to do with budget deficits as a means to ensure high levels of employment in a growing economy (where capacity grows over time) where the non-government sector also desires to save. A private sector investment boom would have caused the same outcome both in inflation and the political problems of fighting it. So will the hyperventilators also say we should not have net private investment?

The historical context is important to understand because it created the political circumstances which have made the hyperinflation inevitable. But these historical vestiges from the colonial white-rule bear very little relevance to the situation that a modern sophisticated fiat monetary system will face.

I am sorry to be so pedantic here, but I think we have to be careful about invoking the hyperinflation argument. There is also an excellent study of Weimar done by Rob Parenteau for those interested.

And, by the way, outside of a currency peg, government does not need taxes to "finance" anything. It is the only entity that can create new net financial assets, which private banks do all the time. The process has to be properly managed, but it can be done.

As a matter of accounting between the sectors, a government budget deficit adds net financial assets (adding to non government savings) available to the private sector and a budget surplus has the opposite effect. The last point requires further explanation as it is crucial to understanding the basis of modern money macroeconomics.

While typically obfuscated in standard textbook treatments, at the heart of national income accounting is an identity – the government deficit (surplus) equals the non-government surplus (deficit). Given effective demand is always equal to actual national income, ex post (meaning that all leakages from the national income flow is matched by equivalent injections), the following sectoral flows accounting identity holds

(G-T) = (S-I) – NX

where the left-hand side depicts the public balance as the difference between government spending G and government taxation T. The right-hand side shows the non-government balance, which is the sum of the private and foreign balances where S is saving, I is investment and NX is net exports. With a consolidated private sector including the foreign sector, total private savings has to equal private investment plus the government budget deficit.

In aggregate, there can be no net savings of financial assets of the non-government sector without cumulative government deficit spending. In a closed economy, NX = 0 and government deficits translate dollar-for-dollar into private domestic surpluses (savings). In an open economy, if we disaggregate the non-government sector into the private and foreign sectors, then total private savings is equal to private investment, the government budget deficit, and net exports, as net exports represent the net financial asset savings of non-residents.

It remains true, however, that the only entity that can provide the non-government sector with net financial assets (net savings) and thereby simultaneously accommodate any net desire to save (financial assets) and thus eliminate unemployment is the currency monopolist – the government. It does this by net spending (G > T). Additionally, and contrary to mainstream rhetoric, yet ironically, necessarily consistent with national income accounting, the systematic pursuit of government budget surpluses (G < T) is dollar-for-dollar manifested as declines in non-government savings. If the aim was to boost the savings of the private domestic sector, when net exports are in deficit, then taxes in aggregate would have to be less than total government spending. That is, a budget deficit (G > T) would be required.

So how do deficits arise? How does the Federal government spend?

The Federal government has cash operating accounts – to ensure that they can spend (G) on a daily basis and receive daily receipts (T). When the Federal government spends it debits these accounts and credits various bank accounts within the commercial banking system. Deposits thus show up in a number of commercial banks as a reflection of the spending. It may issue a cheque and post it to someone in the private sector whereupon that person will deposit the cheque at their bank. It is the same effect as if it had have all been done electronically.

All federal spending happens like this. You will note that:

• Governments do not spend by “printing money”. They spend by creating deposits in the private banking system. Clearly, some currency is in circulation which is “printed” but that is a separate process from the daily spending and taxing flows;

• There has been no mention of where they get the credits and debits come from! The short answer is that the spending comes from no-where but we will have to wait for another blog soon to fully understand that. Suffice to say that the Federal government, as the monopoly issuer of its own currency is not revenue-constrained. This means it does not have to “finance” its spending unlike a household, which uses the fiat currency; and

Any coincident issuing of government debt (bonds) has nothing to do with “financing” the government spending.

Federal spending by the Treasury, for example, amounts to nothing more than the Treasury debiting one of its cash accounts (say by $100m) which means its reserves at the Fed decline by that much and the recipient deposits the cheque for $100m in their private bank and its reserves at the Fed rise by that amount.

Taxation works exactly in reverse. Private bank accounts are debited (and private reserves fall) and the government accounts are credited and their reserves rise. All this is accomplished by accounting entries only. The taxation does not go anywhere! It is not stored anywhere and certainly does not “finance” the spending. The non-government sector cannot pay its taxes until the government has spent! It is a good practice to think of taxes as just draining liquidity from the non-government sector reflecting the Government’s desire for that sector to have less spending capacity.

None of this has anything to do with “feel good drug abuse” or deficit spending as some have relayed in comments to Mr. Hansen’s article.

Sincerely,

Marshall Auerback

2010.05.29 | Jānis Bērziņš

Reading Auerbacks response numerous comments. Most importantly - we do not have a dollar economy world wide. Nor is the Central Bank buying or selling government bonds in countries where the Central Bank (Fed) is independent.

The world is not based on money, but on output/production. If your output does not change, but you keep printing money to sustain a deficit (inflate the economy), then in terms of real world application - your currency looses value, as output stays the same, but there is also more currency. In national currency terms within the national economy there is inflation.

Sure, the U.S. can afford to play this game for a while. But then think back what you could buy for 1$ in 1950ies and what you can buy for 1$ today despite gains in efficiency of production.

Alternatively look at the exchange rate of USD/EUR at introduction in 1990ies and then look at USD/EUR exchange now. (static.seekingalpha.c...)

2010.05.28 | Marshall Auerback

"currency debasement", which is always a fixation of the Austrian crowd - i.e. it only cost me a nickel to buy a candy bar that now costs me $1.00 - is a red herring. You can probably buy a lot more chocolate bars today than you could several generations ago.

If we are going to raise the issue of currency debasement, one also has to ask: what is the average nominal wage level now compared to when you were a child?

Currency debasement can only be a real concept. Comparing to nominal price levels at two points in time of one good or service tells us nothing at all about the movements in the real purchasing power of a unit of account.

PS we still do have a dollar economy worldwide. It is the reserve currency. There is no alternative until other areas, such as China or the EU, are prepared to run current account deficits and allow the rest of the world to accumulate euro or RMB denominated financial assets.

2010.05.31 | Jānis Bērziņš

Real purchasing power has nothing to do with printing currency, but with improving productivity. Productivity can not be achieved unless there is progress.

Having "nominal" value lie through inflation, does nothing for productivity. Realizing reforms, improving efficiency does.

2010.06.01 | Marshall Auerback

Well, I can't seem to get on but my response is: it's hard to describe an economy as "efficient" when about one-fifth isn't gainfully employed. If "efficiency" is the goal, why not just deport the 20% who aren't working, so you'll have supply more in line with demand.

By the way, governments do not spend by “printing money”. They spend by creating deposits in the private banking system. Clearly, some currency is in circulation which is “printed” but that is a separate process from the daily spending and taxing flows

A sovereign government is very different from a household because the household sector is revenue-constrained, it has to sacrifice consumption possibilities now to improve them later. It can increase consumption now beyond income via increasing its indebtedness or selling assets (past saving) but the budget constraint has to be obeyed at all times.

But, of-course, this sort of reasoning doesn’t apply to the government. A budget surplus does not create a cache of money that can be spent later. Government spends by crediting a reserve account. That balance doesn’t “come from anywhere”, as, for example, gold coins would have had to come from somewhere. It is accounted for but that is a different issue.

Mainstream economics uses the government budget constraint framework (GBC) to analyse three alleged forms of public finance: (1) Raising taxes; (2) Selling interest-bearing government debt to the private sector (bonds); and (3) Issuing non-interest bearing high powered money (money creation). Various scenarios are constructed to show that either deficits are inflationary if financed by high-powered money (debt monetisation), or squeeze private sector spending if financed by debt issue. While in reality the Government Budget Constraint (GBC) is just an ex post accounting identity, orthodox economics claims it to be an ex ante financial constraint on government spending.

The GBC framework leads students to believe that unless the government wants to print money and cause inflation it has to raise taxes or sell bonds to get money in order to spend. People have the erroneous understanding that taxation and bond sales provide money for the government which they use to spend. So if the government increases its deficit (spending more than taxing) then it must be increasing its debt holdings or “printing money”, both of which are deemed undesirable.

However the reality is far from this erroneous conception of the way the Federal government operates its budget. First, a household, uses the currency, and therefore must finance its spending beforehand,ex ante, whereas government, the issuer of the currency, necessarily must spend first (credit private bank accounts) before it can subsequently debit private accounts, should it so desire. The government is the source of the funds the private sector requires to pay its taxes and to net save (including the need to maintain transaction balances). Clearly the government is always solvent in terms of its own currency of issue.

Likewise, payments to government reduce reserve balances. Those payments do not “go anywhere” but are merely accounted for. A budget surplus exists only because private income or wealth is reduced.

The consequence of this is that running a budget surplus (T > G) last period, does not increase the capacity of the government to spend this period. Given the government is not revenue-constrained, it can spend whenever there are real goods and services available for sale irrespective of where they have been in the past.

So the “saving” analogy breaks down. The idea that the government saves in its own currency has no meaning.

The only pain that matters relates to the lost income opportunities, the unemployment, the lost housing occupancy, the rising health strains brought on by recession, and all the other pathologies that are well researched in the literature.

This idea that by if you don’t cut back now there will be more pain in the future is the ultimate neo-liberal con job.

Even worse is the notion that this currency peg has brought Latvia great "progress" and higher "productivity gains". In this regard, it is very instructive to look at Argentina.

The lessons of Argentina in 2000 have not been learned. Argentina was roped into a currency board with the US in the 1990s which guaranteed peso-convertibility into US dollars. What this effectively meant was that US monetary policy dominated Argentina – it could not set its own interest rates. This was fine for a short-period while the US economy was growing but by 1996, as the US Federal Reserve tightened monetary policy and risk premia on Argentinean debt rose the appreciating currency started to choke trade.

They had relied on an export-led growth strategy (the “IMF model”). As expected, real growth collapsed and unemployment rose dramatically. The automatic stabilisers pushed the budget deficit and public debt ratio up. So we had a strong US economy trying to choke inflation via contractionary monetary policy pushing that policy onto a weakening Argentine economy via the currency board.

The neo-liberals got to work and demanded labour market deregulation, privatisations and fiscal austerity measures to be introduced. The attention was focused, as it is now, on the meaningless public finance ratios. They became the goal of policy rather than being seen as symptoms of deteriorations in the more appropriate policy targets (for example, growth, unemployment etc).

Conservative academics, as now, produced an array of papers with dazzling (to most) mathematical narratives about how the government could restore growth by dramatically cutting the public deficits. They all argued that unless you take action now to reduce the public debt ratio (heavily denominated in foreign currency because of the currency board) then there would be lower growth in the future. Same arguments as now. Mindless repetition of results drawn from economic models that have no application or meaning in a real monetary system.

The IMF bullied the Argentine government into introducing a harsh debt reduction plan via fiscal contraction. In their Second Review Under the Stand-By Arrangement and Request for Augmentation released in January 2001. They claimed that there would some modest growth damage in the first year but solid growth would return in 2001 and 2002 (see graph below).

The government was also pushed into introducing a raft of neo-liberal policies such as privatisation, deregulation etc all packaged and promoted as “structural reform”, which is code for reducing the size of the public sector and putting more resources into the hands of private enterprise. The austerity program attacked pension and health care systems – dramatically cutting back the generosity of entitlements, coverage etc.

As a result of the hectoring by international agencies and conservative forces within Argentina, the government introduced a harsh fiscal austerity program in late 2000 under the guise of the “Fiscal Pact of November 2000″. The IMF projections were all favourable – debt reduction, growth, reduction in unemployment etc. The Pact was reinforced with more fiscal lunacy in July 2001 in the form of the Zero Deficit Law. The IMF agreed to provide short-term finance given the private bond markets had push risk premia through the roof.

So while the IMF were lauding their macroeconomic credential and blackmailing Argentina into taking more loans from them in return for harsh fiscal austerity, the actual economy was behaving nothing like their model projections. In 2001, the IMF predicted that the economy would grow by 3 per cent whereas, in fact, it shrunk by -4.4 per cent. Things became much worse in 2002 – while the IMF was telling everybody that real GDP growth was going to be 4.5 per cent, by the time the austerity policy impacts had played out the real economy had shrunk a further 10.9 per cent. So by 2002, there was a 16 percentage point gap in the forecast and reality – that is huge.

The IMF should have been disbarred from having anything further to do with any economy after that fiasco – which was just one in many devastations there policy advice caused aroudn the world. And they are still playing the same cards. Evidently, they have a lot of followers in Latvia.

The reality that followed is well documented. This faulty policy strategy saw demand collapse further and unemployment skyrocket. The harsh decline in conditions ultimately led to a social and economic crisis that could not be resolved while it maintained the currency board. In December 2001, the people rioted.

At this point, the government realised it had to adopt a domestically-oriented growth strategy. As soon as Argentina abandoned the currency board, it met the first conditions for gaining policy independence: its exchange rate was no longer tied to the dollar’s performance; its fiscal policy was no longer held hostage to the quantity of dollars the government could accumulate; and its domestic interest rate came under control of its central bank.

One of the first policy initiatives taken by newly elected President Kirchner was a massive job creation program that guaranteed employment for poor heads of households. Within four months, the Plan Jefes y Jefas de Hogar (Head of Households Plan) had created jobs for 2 million participants which was around 13 per cent of the labour force. This not only helped to quell social unrest by providing income to Argentina’s poorest families, but it also put the economy on the road to recovery.

Conservative estimates of the multiplier effect of the increased spending by Jefes workers are that it added a boost of more than 2.5 per cent of GDP. In addition, the program provided needed services and new public infrastructure that encouraged additional private sector spending. Without the flexibility provided by a sovereign, floating, currency, the government would not have been able to promise such a job guarantee.

The data is instructive. The resumption of growth has been strong and persistent (8.8 per cent in 2003, 9.0 per cent in 2004, 9.2 per cent in 2005, 8.5 per cent in 2006 and 8.7 per cent in 2007). Real wages have also risen modestly over the same period.

2010.06.02 | Jānis Bērziņš

I think the missing point of Mr.Auerback is Prof. Hansen's most favourite saying "et ceteris paribus" - "other things being equal". But they are not. Things are not equal. Not even to the slightest.

Latvia is not Argentina.

Argentina was fixed to USD, while only 10% of its exports went to US and eventually the banks just left Argentina without a banking sector.

Latvia is fixed to EUR, where 85% of all export goes to Eurozone and all banks in Latvia have re-affirmed their commitment to the Latvian economy.

In Argentina 2 million people are 13% of the work force. In Latvia 2 million would be 200% of the economically active people (job seekers + employed total). How viable is an internal market?

Argentina is not part of any customs unions. Latvia is a Member of the EU, including part of its goods, services and labor market. To make it simple - basically Latvia is "sort of like a state in the US, only with more sovereignty powers".

You can't just ignore these differences.

2010.06.02 | Marshall Auerback

We tax for two reasons: one is to control something called aggregate demand. We tax if demand is "too hot" and we can lower taxes when demand is "too cold". Fiscal policy is a far more precise means of controlling aggregate demand than monetary policy where the effects are less targeted and more diffuse (for example, even though interest rate rises slow demand for debtors, it clearly enhances the returns for savers and those who own financial assets).

While it may be a fun straw man to create in order to knock it down (no constraint on spending) I am NOT suggesting that government constructs policy on the basis that a government faces NO CONSTRAINT in terms of spending, but that many of the "constraints" that people normally discuss are not identified in an honest manner - which is to say that these commentators import nonsensical notions of "affordability" and "national solvency" (we're getting a lot of this sort of talk today in regard to the US and Japan), when they have no applicability in a post-gold standard world in which government alone creates currency and extrinsically confers value on it via the imposition of a tax liability. Which is the second reason why we tax.

The public would not give up goods and services to the government in return for otherwise worthless coins or paper notes unless there were good reasons to do so. The primary reason the public accepts what we call "fiat money" is because it has tax liabilities to the government. If the tax system were removed, the government would eventually find that its fiat money would lose its ability to purchase goods and services on the market. In the words of Abba Lerner (one of the architects of "functional finance"): “The modern state can make anything it chooses generally acceptable as money…It is true that a simple declaration that such and such is money will not do, even if backed by the most convincing constitutional evidence of the state’s absolute sovereignty. But if the state is willing to accept the proposed money in payment of taxes and other obligations to itself the trick is done.”

Once we accept the reality that the government creates new net financial assets exogenously, it renders notions of "solvency" to be nonsensical. It also means that the household analogy is totally fallacious, given that a household does not have the power to create currency or tax and therefore faces an external constraint unlike a government. Which brings us to the second point of taxation. Again, as Lerner argues: "The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money, and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound or unsound." So we look at the EFFECTS and IMPACTS of government spending. When we reach full employment and inflationary pressures are beginning to develop, this is the constraint faced by a government and it should reduce its spending and/or increase taxation to diminish demand. We're interested in full employment and economic prosperity; we're not auditioning for the role of finance minister in Zimbabwe, as many of our critics allege.

On the issue of California, you have a problem of the user of a currency rather than an issuer of a currency, much like Latvia. Government spending is financed through the issue of currency, taxes generate demand for that currency that results in sales to government, bond sales merely substitute bonds for cash, and central bank operations determine interest rates and defensively add or subtract reserves. The relation of member countries to the European Monetary Union (EMU) is more similar to the relation of the treasuries of member states of the United States to the Fed than it is of the US Treasury to the Fed. In the US, states have no power to create currency; in this circumstance, taxes really do 'finance' state spending and states really do have to borrow (sell bonds to the markets) in order to spend in excess of tax receipts. Purchasers of state bonds do worry about the creditworthiness of states, and the ability of American states to run deficits depends at least in part on the perception of creditworthiness. While it is certainly true that an individual state can always fall back on US government help when required (although the recent experience of California makes that assumption less secure), it is not so clear that the individual countries in the euro zone are as fortunate. Functionally, each nation state operates the way individual American states do, but with ONLY individual state treasuries.

The euro dilemma is somewhat akin to the Latin American dilemma, such as countries like Argentina regularly experienced, or that Latvia is experiencing today. Deficit spending in effect requires borrowing in a "foreign currency", according to the dictates of private markets and the nation states are externally constrained. That's why Iceland and Latvia are in a mess and suffer from solvency issues. It's also why California suffers from a solvency issue or Italy or Spain. Not the US or Japan.

By the way, as an aside, I am not American. I am actually Canadian, a country that has benefited substantially from the immigration of intelligent, highly skilled Latvians. So if your government wants to continue its suicidal economic policies, Canada will gladly continue to be a beneficiary of such economic sadism. I happen to have a real fondness for Latvia, however, and hope (as do my colleagues) that they will embrace a policy which enriches the vast majority of Latvians, not a few economic rentier parasites, which are currently feasting off the country's misery.

2010.06.07 | Morten Hansen

Dear Mr. Auerback

Please allow me just a short reply.

Mr. Auerback ends his article/comment/reply to my ir.lv blog by alleging that I introduce “a red herring designed to distract the readers’ attention”.

If so, Mr. Auerback is even better than I am at that game, alleging that I am “weaker on economics” – and that I have made “a clumsy attempt at deploying guilt by association that was common under the tenure of the “Josephs” (Stalin and McCarthy)” Wauw! Never been likened to those guys before!

But having read his comments I see no reason whatsoever to change my position and I even find it supported by two of his comments: “There has been no mention of where they [the government] get the credits and debits from! The short answer is that the spending comes from nowhere…” and “Federal spending by the Treasury, for example, amounts to nothing more than the Treasury debiting one of its cash accounts (say by $100m) which means its reserves at the Fed decline by that much”.

Classical money financing of deficits!

In the Auerback world the government can buy goods and services for free, in the real world someone eventually has to pay and it will be those who hold domestic currency i.e. via the inflation tax.

It is fine that (S-I) + (T-G) = NX is applied in the analysis but MV = PY should be there too...

PS But I guess I am really “weaker on economics”. I mean, I do not believe myself and I do not try to make anyone else believe that I can solve Latvia’s problems just like that. Mr. Auerback is, however, much more talented – less than a year ago he explained how “Latvia’s problems could be fixed over a weekend”. Follow his 5-point plan and “Full employment and economic prosperity would come in no time at all”.

PPS Back to my alleged red herring: Isn’t it just a tad naïve not to check out in advance who one is supposed to work with? And while it does not disturb my sleep that Mr. Auerback has “never heard of him [me]” it tells us that he hasn’t been looking too much at this web site either….. :)

PPPS At the end of his last comment on this site Mr. Auerback writes that he has “a real fondness for Latvia and hope … that they will embrace a policy which enriches the vast majority of Latvians, not a few economic rentier parasites, which are currently feasting off the country's misery”. Well, I couldn’t agree more!