Deficits Don’t Matter!
Reagan proved deficits don’t matter’ Dick Cheney 2002
The ruling elites in Europe are using the crisis to attempt a final burial of Keynes. The US right-wing, of course, is eager to do the same but the tidal wave won’t fully hit US shores until after November. Liberals in the US are mounting an expectedly lame defense against this onslaught and have already surrendered much of the ground. Paul Krugman, for example, concedes the deficit is a problem and proposes only to delay fiscal austerity until unemployment is reduced to 7%. Is this the best we can offer? Keynes and his immediate followers way back in the 1940’s (Abba Lerner for example) offered some substantial insights into the issue of budget deficits but they seem to have been forgotten. Cheney was right, deficits don’t matter. It’s time we take up his cry.
The whole issue of deficits, in fact, rests on a key underlying assumption – that we need to borrow in order to spend beyond what we collect in taxes – but that assumption is patently false. We as a society do not need to borrow from the financial markets in order to spend dollars – we can create dollars, i.e. purchasing power, directly. This indisputable fact goes against all normal conventions of ‘sound finance’ but please bear with me – it’s not crazy. The issue, simply put, is one of control of the money supply – should it be democratic or must it remain in the hands of high finance.
To make the case, I’d like to take a quick detour and review how money, i.e. purchasing power, expands within the current system. This is a bit dry and if you’re already familiar with the workings of monetary expansion through bank credit you can skip this and the next two paragraphs. Money supply increases in the private economy through the issuance of credit by private banks. If, as an example, the money supply – say bank deposits – is $1 million and a bank extends a $1 million loan to a builder, then the money supply (and thus purchasing power) grows to $2 million. The ultimate limit to such leverage is the required bank capital ratio but that doesn’t really impose a ceiling on money supply growth since profits are generated immediately in the process of credit creation and a portion of those profits could be plowed back into bank capital, and thus continue the process. That profits (savings) are generated immediately as the money supply expands, and are unrelated to the success of the specific venture the credit is advanced for, is an important but often under-appreciated fact. This can easily be demonstrated by tracing the uses of the new credit. If the builder in our example pays a contracting company for supplies, then the contracting company’s profits are immediately increased. If workers are paid wages, profits would immediately be generated in the consumer goods industries.
Important points to be taken from this are: a) that banks have an extremely powerful role in a purely private system because they are the gate keepers of the money supply (purchasing power); b) the money supply will expand to the extent, and only to the extent, that profitable opportunities for investment exist; and c) savings are not needed for investment but rather investment creates savings. But the even more crucial conclusion is that, subject only to the requirements of profit, banks can expand the money supply indefinitely. The private economy, through banks, “prints money”.
The government’s spending role in society began in earnest during the depression as private investment was woefully inadequate to generate sufficient employment. There were ongoing periods of substantial unemployment prior to the depression, but established practice prohibited the government from countering the slack in purchasing power. Government spending has continued to the present day but it is popularly seen as restricted because of limits to the extent of permissible taxation or borrowing. Taxes directly reduce spending power and are naturally resisted. There is no obvious constituency against borrowing but an equivalence between government and individual debt is widely accepted so that borrowing by the government is seen as identical to that of an individual and excessive government debt has all of the same negative connotations. ‘Common sense’ says that debt is self limiting because its continuous growth will either render it impossible for the government to meet its obligations to bond holders or it will eventually lead to crippling taxes on future generations. In practice, then, there are limits to how far the money supply, and therefore societal income, can expand under the accepted view. Those limits are set by the profit opportunities seen by private banks and the limits to how much the government can tax or borrow.
The case being made here is that the ‘common sense’ is misguided and here’s why. 1) The government has no need to either tax or borrow since it controls the dollar and the currency is not backed by any commodity. The dollar is a fiat currency and the government can, like banks, “print money”. 2) Since taxes and borrowing are not needed for spending, clarity requires that their real nature be identified. They must be seen not as funding sources but as monetary tools that reduce the money supply. 3) The government can spend by “printing money” to the extent there are unmet societal needs, limited only by the productive capacity of the economy. If inflation rises to undesired levels, then the government could address the problem monetarily by reducing the money supply through taxes or borrowings or attempt to directly address the forces leading to the pressure. 4) Since borrowing is simply a monetary tool used to reduce the money supply, its level is not to be feared.
The first point is the most central from which the other three emerge. The dollar is a fiat currency. It is not backed by gold, silver, or any other commodity. The US government is the monopoly issuer of the dollar and it can be produced at no cost by simply crediting a bank account. There is no need to borrow or tax to obtain dollars – the government can “print money”. This is a well known and indisputable fact but despite its simplicity, it exposes the fundamental error of thinking deficits are important. Since it’s true that the government has no need to borrow or tax in order to spend, taxes and borrowing must be understood as performing a different role. And that role can only be to reduce the money supply. This is not too disturbing to the consensus view as the Fed routinely executes borrowing transactions for just that purpose. Borrowing and taxes are then tools for adjusting the money supply and are not ways the government obtains funds. This is the central insight.
Spending, taxing, and borrowing must be seen as separate operations within an overall monetary policy. Spending – be it on investment, social programs, or income enhancements – will increase the purchasing power of society by increasing the money supply. The government would simply credit the appropriate bank accounts. Taxes do not provide funds for government spending since they are not needed – they simply reduce purchasing power by draining money supply from the system. Borrowing performs the same function as taxation – it does not provide funds for spending but rather serves the purpose of draining purchasing power by reducing the money supply.
These three interventions are tools the government can use in order to promote maximum prosperity. The government can spend, i.e. “print money” for unmet social needs, limited only by the capacity of the economy, and could perform some combination of taxation or borrowing to drain money supply from the system if it is seen as too great. The critical point, again, is that taxes and borrowings are not transactions to obtain funds for spending but are monetary operations performed to reduce the money supply.
What would happen if the government did not tax or borrow? The money supply would continuously rise and interest rates would fall, probably to zero. This would be a highly advantageous event for society as it would largely eliminate the power of capital to extract rentier income. Some balance of taxes or borrowings would likely be required, though, in order to drain excess money supply if inflationary pressures rise. Should the government find it desirable to raise the interest rate, it could accomplish this task by instituting the monetary tool of borrowing.
Most observers will readily agree that the government is able to print money and would perhaps grudgingly go along with the notion that borrowing and taxes are essentially monetary operations (points one and two). Vigorous disagreements will arise, though, with points three and four – the views that the government can soundly print money for unmet societal needs and that the level of debt is of no concern.
The most predominant objection will be that “printing money” is unsound because it will inevitably lead to inflation. Money supply expands in the process of “printing money” – either privately through bank credit, or governmentally – but this is not inherently inflationary as long as there are underutilized resources. The argument that spending per se is inflationary necessarily rests on the belief that the economy is already at or approaching full capacity and this is a case that can rarely be made. Those who argue in this direction are inconsistent when they object to government spending while taking no exception to private credit expansion that is identical in effect.
Unlimited printing of money without consideration of the productive constraints within an economy can undoubtedly be inflationary. But this is a straw man argument. The case being made is that the government can spend to meet social needs to the extent permitted by the capacity of the economy. There is no widely accepted consensus on inflation, but the historical record can help us make informed conclusions. The major bout of inflation in postwar history occurred in the late 1960’s through the 1970’s and essentially ended with the severe recession in the early 1980’s. It seems likely that the major cause was a class struggle over income distribution leading to a wage-price spiral. The major players in the economy then, as now, were large corporations in oligopolistic markets. These companies had substantial pricing power and priced based on internal costs, the largest of which was wages. Unions were powerful then and were able to obtain fairly large wage increases. Companies, though, having pricing power, were able to pass on the increased cost through higher prices, resulting in the spiral. Increased oil and commodity prices also had their effect. Bottlenecks and high capacity utilization are also potential instigators of inflation but it must be remembered that under-utilization is the endemic norm of the system. The boom in the latter 1990’s saw high levels of economic activity, rapid expansions in the money supply fueled by debt, and low unemployment, yet inflation was tame. The probable difference between this boom and the 1970’s was the lack of worker mobilization caused by the demise of unions, increased labor competition from foreign sources, and the corresponding power of capital to constrain wage growth. One can conclude that inflation has a large political element and it is not primarily an outgrowth of the cold economic calculus of supply and demand.
Should unacceptable inflationary pressures arise, the government could first seek to rectify the bottlenecks or power positions that were creating the pressures. But it can always utilize the monetary tools of taxation or borrowing to reduce the money supply. In a low inflationary environment in which substantial slack exists, clearly the situation in 2010, there is absolutely no reason for the government to refrain from needed spending.
Government spending in the manner discussed here is very relevant to another and interrelated misconception – the deep-seated belief that exports are the ultimate solution to a nation’s economic problems. Exports are almost universally seen as critical for domestic prosperity. They are the basis of the rise of the East Asian economies, the staple of Germany, and the expansion of foreign markets has been the bedrock of US foreign policy since the late 19th century. Competition for export growth is now driving the world into an era of mercantilism very similar to that existing prior to World War I. Exports are a zero sum game but if a nation is successful, they are a way of stimulating employment by showering purchasing power onto an economy from a source outside it. But if exports could be the answer, why not instead export to yourself through government spending? A fiat currency regime allows exactly this since government spending has exactly the same effect as export income. In both cases, currency flows into the economy from outside it. The simple fact is that we don’t need an outsider to provide us with purchasing power – we can generate it ourselves. It would be as if a culture from outer space suddenly emerged that was willing and able to import all our goods and services.
Many believe “printing money” is not only unsound but also somehow immoral. It is neither and, to repeat, it is inconsistent to approve of the private printing of money through bank credit while disapproving the same actions on the part of society. Societal control of purchasing power would represent a significant step toward prosperity, full employment, and peace. Failure to even consider this option locks us into a cage of austerity, unemployment, and mercantilism in which each state desperately seeks foreign export markets.
We’ve now made a case for the first three points – the government has no need to borrow or tax since it can “print money”, borrowings are actually monetary operations that reduce the money supply, and the government can spend to the extent of societal needs limited only by the capacity of the economy. We still need to expand on our fourth point and show that borrowing is not to be feared.
We must first notice that the word itself is now greatly diminished. We are no longer referring to a normal debt relationship in which a debtor seeks funds from a creditor to enable spending and in which the debtor faces a real burden of repayment. In fact, the word is totally inappropriate and we see that simple linguistics is the source of much of the confusion. It is far truer to call government borrowing a reserve activity in the same sense as a bank maintains reserves at the Fed. There is no concern about an unsustainable burden arising from reserve balances at the Fed and the same should apply with government debt.
But let’s dig deeper into borrowing as it is widely understood. Based on what has previously been discussed, borrowing would only be needed to reduce the money supply beyond what is accomplished with taxes and would only be required when the economy is expanding faster than desired. There would be no need for borrowing when the economy is slow and it could be reduced. Over an entire cycle, it is very possible that the overall “debt” would be stable. Interest rates should be low due to the increased money supply and this would reduce any economic distortions from interest payments. Also, society could assess a tax on capital of just a few percentage points which would completely offset interest payments. Debt is not a burden on future generations, as is often claimed, but rather a distributional issue within that generation. The future generation will pay interest but that interest will be paid to bond holders of that generation. Except for foreign debt, it is a net wash for the future generation.
Addressing the problem in the manner of the preceding paragraph, though, cedes way too much – we need to focus on the fact that a debt which can be repaid without cost is no burden. Borrowing should be reclassified as reserves and a strong case can be made to require all holders of wealth beyond a certain point to deposit reserves with the Fed just like private banks. The required reserve ratio could then adjust according to monetary policy.
In today’s environment, the government should not be “borrowing” but should rather be increasing the money supply through spending and borrowing reductions. What of foreign debt? That debt should probably be repaid, either immediately or as it becomes due. But that decision should be made based on inflationary considerations existing at the time.
The focus on borrowings, i.e. the budget deficit, is therefore completely misguided as long as the government controls the currency. The Euro was instituted without a full political union and the individual governments therefore do not control the currency. This is a crucial weakness that will cause much pain to the average European until such time as either a true union becomes possible or the Euro is dissolved.
The most passionate objection, and also the underlying motivation for many who tirelessly construct sophisticated technical arguments, will be political – that such policies represent an undue intrusion of government into the private market. This line of thought has a long history but its popular manifestations absurdly conflate the interests of society with those of great wealth and the organized representatives of society with tyranny. Control over the money supply conveys a great deal of power and one can expect those who control it today will strongly object to losing it. Capital currently exercises extraordinary power in world affairs. The money supply will not expand without its confidence in future profit levels, capital readily locates offshore or flees a country to avoid taxes, and governments are brought to their knees when their budget deficits are seen as excessive. Sovereignty is the ultimate issue here and society must ultimately decide whether it wishes to assert it or allow it to remain uncontested in the hands of the wealthy few. The question also needs to be asked to supporters of the status quo: do you have anything better to propose other than austerity or a mercantilist zero sum export war?
The answer to today’s ‘deficit problem’ is not new consumption taxes or reduced government spending. We must reject the very definition of the problem as defined by financial orthodoxy. Budget deficits are not real constraints to spending. They are, in fact, a ruse that maintains the status quo. There are only two real constraints: our productive capacity and the environment. Inflation control is a real issue, deficits are not.