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Why national accounts might be like corporate balance-sheets
A new paper argues that fiat money is like equity
THE easiest way to get an economist to laugh sardonically is to compare a country’s finances to those of a family. It is both simplistic and wrong, they will argue, for politicians to say that a country “must live within its means”.
But in a new working paper* from the National Bureau of Economic Research, Patrick Bolton and Haizhou Huang make a different comparison; between the finances of a government and those of a company. A business can finance itself in three ways: through internal funds (its revenues); through borrowing; and through equity (the issuance of new shares). In the first two cases, it is easy to see the analogy with a nation state; governments can raise money from taxes or borrow in the form of government bonds.
But the paper’s most striking idea is that the national equivalent of equity is fiat money.
Governments are able to issue money that can be used to settle debts and pay taxes—the term “fiat” comes from the Latin for “let it be done”. Equity gives its holders a claim on the assets and profits of a company; money gives its holders (citizens) a claim on the goods and services produced by a country.
Inflation can be explained with another analogy. If a company issues shares to new investors for less than their true value, the holding of existing shareholders is diluted. “Similarly when a nation issues more money to new holders while adding less real output than the purchasing power of money, then existing holders of money are also diluted in proportion to the transfer of value,” the authors write.
The authors draw a parallel with a well-known concept in corporate finance—the Modigliani-Miller theorem. Franco Modigliani and Merton Miller proposed that, in the absence of a range of complex factors like taxes and bankruptcy costs, the value of a company should be unaffected by how it is financed.
To spell this out: the enterprise value of a company represents the combined value of its shares and bonds. The bondholders have first claim on its cashflows. If the company suddenly issues a lot of bonds, its shares will become more risky and will fall in value, but the overall enterprise value will be unchanged.
With the help of some fancy maths, the authors say that a similar argument can be applied to national finances. Assume that a country wants to invest to improve its productive capability. It can choose to finance these investments by borrowing in foreign currency or issuing fiat money. In an economy without “frictions”, it should not matter which of these options it chooses. A version of the Modigliani-Miller theorem thus applies.
In the real world, of course, there are bound to be frictions. One of these is a side-effect of inflation. This may not be a problem in an ideal economy. Consider a stock split; some companies with high nominal share prices issue new shares on a pro-rata basis. So a company with 10m shares trading at $500 each could issue another 10m shares; the price should fall to $250 and the overall value of the company would be unchanged. No one loses.
If governments issuing new fiat money could distribute it equally to each citizen, the same arguments would apply. Instead, however, governments tend to use new money to buy financial assets, or goods and services. So the gains are not evenly distributed. This is the real cost of fiat-money issuance—the transfer of wealth from some citizens to others.
But borrowing also brings risks. A country with too high a debt ratio may default on its foreign-currency obligations. The result may be a shock: much higher interest rates or lost access to the credit markets that may damage the economy. So when a rational government finances investments, it is choosing between the redistribution risks caused by inflation and the risk of default on foreign debts.
It is an intriguing way of formulating the debate, particularly in the light of the extensive use of quantitative easing by central banks since the financial crisis broke in 2008. This has caused less inflation than many feared, which has led some economists to argue that there is little constraint on the ability of rich-world governments to finance their spending, provided a central bank is willing to issue fiat money at will. But what counts is confidence. Countries can find eager takers for their debts and willing holders of their money. Until, at some point, they won’t accept them any more. Predicting when that point occurs is the tricky task, for economists and non-economists alike.
* The Capital Structure of Nations, NBER working paper 23612
But in a new working paper* from the National Bureau of Economic Research, Patrick Bolton and Haizhou Huang make a different comparison; between the finances of a government and those of a company. A business can finance itself in three ways: through internal funds (its revenues); through borrowing; and through equity (the issuance of new shares). In the first two cases, it is easy to see the analogy with a nation state; governments can raise money from taxes or borrow in the form of government bonds.
Governments are able to issue money that can be used to settle debts and pay taxes—the term “fiat” comes from the Latin for “let it be done”. Equity gives its holders a claim on the assets and profits of a company; money gives its holders (citizens) a claim on the goods and services produced by a country.
Inflation can be explained with another analogy. If a company issues shares to new investors for less than their true value, the holding of existing shareholders is diluted. “Similarly when a nation issues more money to new holders while adding less real output than the purchasing power of money, then existing holders of money are also diluted in proportion to the transfer of value,” the authors write.
The authors draw a parallel with a well-known concept in corporate finance—the Modigliani-Miller theorem. Franco Modigliani and Merton Miller proposed that, in the absence of a range of complex factors like taxes and bankruptcy costs, the value of a company should be unaffected by how it is financed.
To spell this out: the enterprise value of a company represents the combined value of its shares and bonds. The bondholders have first claim on its cashflows. If the company suddenly issues a lot of bonds, its shares will become more risky and will fall in value, but the overall enterprise value will be unchanged.
With the help of some fancy maths, the authors say that a similar argument can be applied to national finances. Assume that a country wants to invest to improve its productive capability. It can choose to finance these investments by borrowing in foreign currency or issuing fiat money. In an economy without “frictions”, it should not matter which of these options it chooses. A version of the Modigliani-Miller theorem thus applies.
If governments issuing new fiat money could distribute it equally to each citizen, the same arguments would apply. Instead, however, governments tend to use new money to buy financial assets, or goods and services. So the gains are not evenly distributed. This is the real cost of fiat-money issuance—the transfer of wealth from some citizens to others.
But borrowing also brings risks. A country with too high a debt ratio may default on its foreign-currency obligations. The result may be a shock: much higher interest rates or lost access to the credit markets that may damage the economy. So when a rational government finances investments, it is choosing between the redistribution risks caused by inflation and the risk of default on foreign debts.
It is an intriguing way of formulating the debate, particularly in the light of the extensive use of quantitative easing by central banks since the financial crisis broke in 2008. This has caused less inflation than many feared, which has led some economists to argue that there is little constraint on the ability of rich-world governments to finance their spending, provided a central bank is willing to issue fiat money at will. But what counts is confidence. Countries can find eager takers for their debts and willing holders of their money. Until, at some point, they won’t accept them any more. Predicting when that point occurs is the tricky task, for economists and non-economists alike.
* The Capital Structure of Nations, NBER working paper 23612
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