Last time we looked at inflation as a "tax' from the incomes perspective. We established that the devaluation of the dollar (i.e: price inflation) over the last century is completely irrelevant, as average incomes have vastly beaten inflation. So in short, Ron Paul's diatribes, that the sky is falling, the dollar lost 95% of its value, while technically correct, is very deceptive. He conveniently ignores the fact that average incomes have vastly beaten inflation [1].
Along the same vein is the Paul's claim that inflation is a "tax" on savings. That would be a valid point, if we lived in a parallel universe where everybody holds most of their savings in cash. Clearly we don't, but let us look at actual data for verification.
A recent academic study looked at the wealth distribution of Americans from 1983-2007 (pdf). Let us look at the non-home net wealth distribution (mostly financial) during the period (see page 46). You see four distinct classes. First, the bottom 40% with an average net non-home wealth of -$10,500 (yes negative). Then, the 3rd quintile (40-60 percentile) with little net non-home wealth on average (just $26,500). Then, there is the 4th quintile (60-80 percentile) with a modest $135,700 on average. And finally, we have the top quintile with an average non-home net wealth of $1,863,600.
Paul's argument is completely irrelevant for those bottom 40%, who have no savings. They live paycheck to paycheck. A little inflation, will actually help reduce their debt burden. Thus real income gains are what matters to these folks. I will cover, in the next section, why is it they have no savings. For the top 3 quintiles, their non-home investments beat inflation on average by 122%, 87% and 66% over 24 years. Even the 3rd quintile who had no REAL (i.e adjusted for inflation) income gains in the same period, gained 66% in their financial investments. I will grant you, this was in 2007 before the financial crisis. By 2012, average cumulative returns were cut by 25%. They still beat inflation. The point is that, real people, who have actual savings are clearly NOT holding 100% cash. If they were, the average REAL return would have been negative 52%.
In reality, as of 2007 the average American held just 6.6% in liquid assets, (see pg.47). This study doesn't break down how much of these liquid assets were held in cash. Fortunately, the Fed flow of funds (FOF) does break it down. See Table B.100 line 11 (pdf). Currency and checking accounts amount to just 0.11% of total household assets in 2007 [2]. Even in Q4 2011, it is still only 0.42% (of total assets). Besides, the "liquid assets" category in the study includes money markets funds, online savings accounts and CD's. And even they beat inflation when the target Fed Funds Rate (FFR) is a real rate (i.e set above inflation). And you can see from this chart, normally the FFR is indeed set to a positive real rate. Before the FFR rate cuts in late 2007, CDs, and even online savings accounts beat inflation.
So to say that inflation is a tax on savings is outright propaganda. Not on actual savings of real Americans. Clearly real Americans are not stuffing cash into mattresses. When the FFR is set to a positive real rate, as it usually is, even grandmothers can beat inflation [3].
The Real Tax on Savings
You know what is really a tax on savings, bank engineered financial crises. The average American lost 25% of their total net wealth due to the Great recession of 2007. Some of the lower quintiles lost as much 50% of their net wealth, as more of their wealth is tied up in their homes. Now, that is the real tax on savings. During the 50 years from the mid 1930s to the mid 80s, there were no significant financial crises, as banks were tightly collared. There were a few mild recessions, but not a single one was due to a financial crisis [4].
But is Paul for collaring banks? No, he wants them to be even more free. He wants to take us back to the 19th century era of free banking. This was a time, when there were financial panics every 2 years. I am not kidding... On average, from 1836-1929 there was literally a recession 2 years after the end of the previous one. And most of them were caused by financial panics. A total of 19 recessions and 5 depressions including the Great Depression [5]. This was time when many people actually kept their money in mattress,
because if they kept it in a bank, their savings along with the bank
could go poof one day [6]. Talk about a tax on saving, but apparently that's okay
because banks are free...
Wonder why is it that the bottom 40% don't have any savings? It wasn't always the case. During the New deal Era (1933-1973) average earned income of the bottom 90%, beat inflation by 405% (4.13%/yr), while during the market liberalization era (1979-2006) it was just 1.6% (0.059%/yr). Yes really, a cumulative 1.6% REAL income gain over 27 years [7]. Three decades of market liberalization, have transferred more and more income to the top 1% from the bottom 90%.
From 1979-2006 the top 1% captured 62.5% of the average REAL income gains. The top 5% captured 84.9%. On the other hand the bottom 90% captured just 4% in those 27 years!! In stark contrast, from 1933-1973 the bottom 90% captured 70.6% of the average real income gains [8]. It doesn't take a genius to figure out that the bottom 40% took the brunt of the upward income transfers since 1979. And wonder why they have no savings...
The real tax on savings is not inflation, it is under-regulated banking and excessive market liberalization. But yet, Paul's supporters claim that he represents the interests of the average American. If he was, he would be for tightly regulated banking, and rolling back three decades of market liberalization. But his actual views are diametrically opposite. The bottom 90% fared vastly better during 1933-1973, when finance was tightly controlled, and top marginal taxes were high. Hell, even the bottom half of the top 1% fared better back then.
Notes
1. Paul's claim is even more irrelevant, given that nominal average incomes should at least keep pace with inflation, as prices are income for producers. Most consumers are also producers. Your income derives from your role in the production of a good or service. But of course, it is true, income gains may not be distributed evenly. Obviously when there are real gains, incomes beat inflation. Average incomes beat inflation by 230% from 1913-2006.
2. While the Levy Institute study only includes households, the FOF table B.100, not only includes households, but also non-profit institutions and for some reason domestic hedge funds. B.100 seems to be a "rest of" category, after taking into account corporations, banks etc: So households themselves probably held more than 0.11% in cash and checking. But it is definitely well below 6.6%.
3. Of course, if the FFR is set to a negative real rate for a long time, average savings may (but not necessarily) fall behind inflation. It may not as liquid assets are only 6.6% of total assets. Homes are a big component of total assets, and a low FFR helps somewhat in that regard, enabling low mortgage rates. Mortgage rates are based on 10 yr treasuries, and 10yr treasury bonds have never deviated more than +/- 4% from the FFR. But, what is root cause for the target FFR to be set low right now? Economic weakness due to the bank engineered financial crisis. The root cause is again under-regulated banking.
4. The recession of 1937 was the only severe recession during this period. It was primarily due to FDR balancing the budget. But he quickly reverted and resumed even bigger deficit spending than before. Thus recovery came quickly and the recession was over in about a year. From 1938-39 Real GDP increased 8.1%, 39-40: 8.8%, 40-41: 17.9% etc:
5. Even though the creation of the Fed in 1913 ended the free-banking era, finance remained unregulated. That is why I am including the period after 1913.
6. This is one of the root causes of the Great Depression. 10,000 banks failed from 1929-1933. While that in itself is not a major issue, there was no deposit insurance back then. So when a bank failed, customers lost their savings, which led to further reductions in consumer spending, further steepening the recession.
7. All average earned income figures are in 2006 dollars. Keep in mind nominal income for bottom 90% increased by 163% from 1979-2006, prices rose 159% using CPI-U RS data set. Thus average incomes beat inflation by just 1.6%. Source: UC Berkley Table A4 based on IRS data
8. Table A6 from same source above in 2006 dollars. Table A4 excludes capital income, A6 includes all income. The same analysis can be found at this interactive chart from EPI. Same UCB source but in 2008 dollars.
Sunday, April 1, 2012
Saturday, February 25, 2012
No, the dollar did NOT really lose 95% of its value since 1913
There is a chart making the rounds lately, that claims the dollar lost 96.2% of it value since 1900. One of Ron Paul's fav talking points. Though technically true in a very narrow sense, if you look at average incomes during the same period, it is clear why this is deceptive. Additionally, the way the line chart is presented is highly deceptive. It makes it seem that there has been higher inflation in the last 40 years. But if you look at the actual numbers in the chart, that is clearly not the case. See the last 2 paragraphs for more detail.
Let us take at the period from 1913-2006, where we have complete data. So what do they mean, when they say the dollar lost 95.1% of its value in those 93 years? Essentially, an average good/service that cost $1 in 2006, used to be priced at 4.9 cents in 1913. In other words, the average price level of goods/services increased by 1930% since 1913. True, but guess what, average earned income increased by 6560% during the same time period. Average earned income rose from $740/yr in 1913 to $49,300/yr in 2006. Adjusting for inflation, $740/yr in 1913 is $15,000/yr in 2006 dollars. Average incomes, not only kept pace, but beat price inflation by 230%.
So does it make any sense all to say the dollar lost value? In reality, the REAL purchasing power of the average American, has increased by 230% in the past century. Sure, prices were cheap in 1913, but $740/yr doesn't buy you a whole lot, not anymore than 15,000/yr today. Even this statistic doesn't fully capture the quality of life gains of the last century. A household making $15,000/yr today is well below the poverty line, but yet, they are highly likely to have a refrigerator, indoor plumbing, electricity, tv, cell phone and maybe even heating and cooling. They are highly likely to have government help in making ends meet - food stamps, subsidized housing, Medicaid etc:. And yeah, thanks to advances in medicine, they don't have to worry about half their children dying before the age of 5. Their analogue in 1913, making $740/yr had none of these "luxuries". And that was the average income... Can you imagine what the poverty line looked like then?
Anyone who says the dollar lost value, is really trying to sell the false point of view, that somehow things were better off in 1913. Seriously?? Maybe we should send them back in time to live in the slums of New York. Yeah, we had actual slums back then. Update 3/2/2012: Yes, technically, in the parlance of mainstream economics, the dollar dropped in value. But, anytime Ron Paul says the dollar lost 95% of it value, but conveniently ignores the fact that average incomes and average savings beat price inflation, he is deceiving the American public. The fact the incomes and savings beat inflation, it makes the "fall" in the dollar completely irrelevant. What I am saying is we need a change in terminology.
Further more, according to the ridiculous logic in the article, the dollar "gained" in value during the great depression. This must have been a very prosperous time. Maybe we should start another depression so the dollar can "gain" in value. The dollar "gaining" in value is deflation, and that is rarely a good thing, especially for debtors. Deflation doesn't usually happen in prosperous economic times. The question should not be whether the dollar "gains" or "loses" in value. The question should be, will incomes beat inflation? That is the real metric of progress.
During the pre-depression years (1913-1929) average incomes barely kept up with inflation. During the market liberalization era (1979-2006), things were slightly better, but not by much. Average incomes beat inflation by just 22%. Most of the real income gains of the last century came during the high tax, "big" government New Deal era (1933-1973), when average REAL income increased from $9,980/yr to $40,500/yr. In other words, average incomes beat inflation by 300%. Had real average income grown at the same rate during 1979-2006, it would be $97,200/yr in 2006!! The contrast is even more stark, if you look at average real income of just the bottom 90%. For them, average incomes beat inflation by 400% during 1933-1973, as opposed to 1.6% during 1979-2006![1]
In addition, the line chart showing the price level, is highly deceptive. It makes it seem like there has been higher inflation for the last 40 years. But, inflation is not a linear dataset[2]. Note that the 2nd highest inflationary period in the chart was 1910-1920, when the dollar "lost" half its value (and yes that was during the gold standard). In other words inflation was 100% in the 1910s, while it was 33% in the 1990s and 28% in the 2000s But yet the chart makes it look like the 1990s and 2000s have a steeper slope than the 1910s. If the chart were accurately depicted they would use percentages. This is how Fox news style propaganda works, take factual data and present it in a deceptive way, to sell a false point of view.
Perhaps the point of view they are selling, is that inflation has been higher due to the termination of gold convertibility in 1971. And it does seem many of the post's commenters perceive it that way. That is clearly, not the case, inflation was pretty normal for most of the 80, 90s and 00s. Yes, the 1970s was the decade with highest inflation rate at 104% (just beat the 1910s by 4% points). But, the primary reason for high inflation in the 1970's and early 1980s were the twin oil shocks of 1973 and 1979. If you compare inflation vs crude oil prices from 1973-1984, they track pretty close together. Crude oil prices nearly tripled within a few months starting in late 1973, and that is not going to affect the prices for other goods? You know, oil is used for transportation of other goods. What a coincidence that inflation peaked right after the oil shocks, twice. What a coincidence inflation subsided, right after crude oil prices fell of a cliff in 1982-83. Nothing whatsoever to do with termination of gold convertibility.
Update 3/1/2012:
Many Ron Paul supporters make the argument that the real value of a dollar saved in 1913, would only be worth 5 cents if spent today. Yes, that would be a valid point, if we assume, that we live in a parallel universe where everybody holds mostly cash savings. Let us look at data from the real world, that looks at non-home wealth distribution (mostly financial) from 1983-2007. See page 46 in the pdf. You see three distinct classes. First, the bottom 40% household with an average net financial wealth of $-10,500(yes negative). Then, the 3rd quintile (40-60 percentile) who have little net financial wealth on average (just $26,500). And finally, there is the 4th and top quintile who have most of US net financial wealth.
Paul's argument is completely irrelevant for those bottom 40%, who have no savings. They live paycheck to paycheck. A little inflation, will actually help reduce their debt burden. Thus real income gains are what matters for these folks, and to enable that we should rollback market liberalization .[3] For the top 3 quintiles, their non-home investments beat inflation on average by 122%, 83% and 66% in 24 years. Even the 3rd quintile who had no REAL income gains in the same period, gained 66% in their financial investments.
I will grant you, this was in 2007 before the financial crisis. By 2012, at most the cumulative returns were cut by half. They still beat inflation. The point is real people, who have actual savings are clearly NOT holding 100% cash. If they were the average REAL return would have been negative 52%. In reality, liquid assets only comprise 6.6% of all assets in 2007. Obviously this category include money market accounts. Hell, even money market accounts and online savings accounts had returns that beat inflation 5 years ago, before the Fed funds rate was cut. Same was true of time deposits. And usually in normal times the FFR is set higher than inflation.
Notes:
1. All average income figures in chart and rest of blog in 2006 dollars. Source: Emmanuel Saez UC Berkeley Table A4 based on IRS data
2. Inflation isn't linear. If you have 9% inflation/yr over 10 years, the price level doesn't increase by 90%. It increased by 1.0910 = 2.37 or 137% . From 1910-1920 the price index rose from 1.1 to 2.2, while in 1990-2000 14.7 to 19.6. Which decade shows greater price inflation? The line chart deceptively makes it seem like it was the 90s. But, really prices doubled (100% increase) in the 1910s, while it only rose 33% in the 1990s.
3. The main reason the bottom 40% are in this quandary, is due to market liberalization, as more and more share went to top 1%, less went to them. That wasn't always the case, from 1933-1973 the average income of the bottom 90% beat inflation by 400%.
Let us take at the period from 1913-2006, where we have complete data. So what do they mean, when they say the dollar lost 95.1% of its value in those 93 years? Essentially, an average good/service that cost $1 in 2006, used to be priced at 4.9 cents in 1913. In other words, the average price level of goods/services increased by 1930% since 1913. True, but guess what, average earned income increased by 6560% during the same time period. Average earned income rose from $740/yr in 1913 to $49,300/yr in 2006. Adjusting for inflation, $740/yr in 1913 is $15,000/yr in 2006 dollars. Average incomes, not only kept pace, but beat price inflation by 230%.
So does it make any sense all to say the dollar lost value? In reality, the REAL purchasing power of the average American, has increased by 230% in the past century. Sure, prices were cheap in 1913, but $740/yr doesn't buy you a whole lot, not anymore than 15,000/yr today. Even this statistic doesn't fully capture the quality of life gains of the last century. A household making $15,000/yr today is well below the poverty line, but yet, they are highly likely to have a refrigerator, indoor plumbing, electricity, tv, cell phone and maybe even heating and cooling. They are highly likely to have government help in making ends meet - food stamps, subsidized housing, Medicaid etc:. And yeah, thanks to advances in medicine, they don't have to worry about half their children dying before the age of 5. Their analogue in 1913, making $740/yr had none of these "luxuries". And that was the average income... Can you imagine what the poverty line looked like then?
Anyone who says the dollar lost value, is really trying to sell the false point of view, that somehow things were better off in 1913. Seriously?? Maybe we should send them back in time to live in the slums of New York. Yeah, we had actual slums back then. Update 3/2/2012: Yes, technically, in the parlance of mainstream economics, the dollar dropped in value. But, anytime Ron Paul says the dollar lost 95% of it value, but conveniently ignores the fact that average incomes and average savings beat price inflation, he is deceiving the American public. The fact the incomes and savings beat inflation, it makes the "fall" in the dollar completely irrelevant. What I am saying is we need a change in terminology.
 |
| Inflation Adjust Average Income 1913-2006 (2006 dollars) h/t visualizingeconomics.com |
Further more, according to the ridiculous logic in the article, the dollar "gained" in value during the great depression. This must have been a very prosperous time. Maybe we should start another depression so the dollar can "gain" in value. The dollar "gaining" in value is deflation, and that is rarely a good thing, especially for debtors. Deflation doesn't usually happen in prosperous economic times. The question should not be whether the dollar "gains" or "loses" in value. The question should be, will incomes beat inflation? That is the real metric of progress.
During the pre-depression years (1913-1929) average incomes barely kept up with inflation. During the market liberalization era (1979-2006), things were slightly better, but not by much. Average incomes beat inflation by just 22%. Most of the real income gains of the last century came during the high tax, "big" government New Deal era (1933-1973), when average REAL income increased from $9,980/yr to $40,500/yr. In other words, average incomes beat inflation by 300%. Had real average income grown at the same rate during 1979-2006, it would be $97,200/yr in 2006!! The contrast is even more stark, if you look at average real income of just the bottom 90%. For them, average incomes beat inflation by 400% during 1933-1973, as opposed to 1.6% during 1979-2006![1]
In addition, the line chart showing the price level, is highly deceptive. It makes it seem like there has been higher inflation for the last 40 years. But, inflation is not a linear dataset[2]. Note that the 2nd highest inflationary period in the chart was 1910-1920, when the dollar "lost" half its value (and yes that was during the gold standard). In other words inflation was 100% in the 1910s, while it was 33% in the 1990s and 28% in the 2000s But yet the chart makes it look like the 1990s and 2000s have a steeper slope than the 1910s. If the chart were accurately depicted they would use percentages. This is how Fox news style propaganda works, take factual data and present it in a deceptive way, to sell a false point of view.
Perhaps the point of view they are selling, is that inflation has been higher due to the termination of gold convertibility in 1971. And it does seem many of the post's commenters perceive it that way. That is clearly, not the case, inflation was pretty normal for most of the 80, 90s and 00s. Yes, the 1970s was the decade with highest inflation rate at 104% (just beat the 1910s by 4% points). But, the primary reason for high inflation in the 1970's and early 1980s were the twin oil shocks of 1973 and 1979. If you compare inflation vs crude oil prices from 1973-1984, they track pretty close together. Crude oil prices nearly tripled within a few months starting in late 1973, and that is not going to affect the prices for other goods? You know, oil is used for transportation of other goods. What a coincidence that inflation peaked right after the oil shocks, twice. What a coincidence inflation subsided, right after crude oil prices fell of a cliff in 1982-83. Nothing whatsoever to do with termination of gold convertibility.
Update 3/1/2012:
Many Ron Paul supporters make the argument that the real value of a dollar saved in 1913, would only be worth 5 cents if spent today. Yes, that would be a valid point, if we assume, that we live in a parallel universe where everybody holds mostly cash savings. Let us look at data from the real world, that looks at non-home wealth distribution (mostly financial) from 1983-2007. See page 46 in the pdf. You see three distinct classes. First, the bottom 40% household with an average net financial wealth of $-10,500(yes negative). Then, the 3rd quintile (40-60 percentile) who have little net financial wealth on average (just $26,500). And finally, there is the 4th and top quintile who have most of US net financial wealth.
Paul's argument is completely irrelevant for those bottom 40%, who have no savings. They live paycheck to paycheck. A little inflation, will actually help reduce their debt burden. Thus real income gains are what matters for these folks, and to enable that we should rollback market liberalization .[3] For the top 3 quintiles, their non-home investments beat inflation on average by 122%, 83% and 66% in 24 years. Even the 3rd quintile who had no REAL income gains in the same period, gained 66% in their financial investments.
I will grant you, this was in 2007 before the financial crisis. By 2012, at most the cumulative returns were cut by half. They still beat inflation. The point is real people, who have actual savings are clearly NOT holding 100% cash. If they were the average REAL return would have been negative 52%. In reality, liquid assets only comprise 6.6% of all assets in 2007. Obviously this category include money market accounts. Hell, even money market accounts and online savings accounts had returns that beat inflation 5 years ago, before the Fed funds rate was cut. Same was true of time deposits. And usually in normal times the FFR is set higher than inflation.
Notes:
1. All average income figures in chart and rest of blog in 2006 dollars. Source: Emmanuel Saez UC Berkeley Table A4 based on IRS data
2. Inflation isn't linear. If you have 9% inflation/yr over 10 years, the price level doesn't increase by 90%. It increased by 1.0910 = 2.37 or 137% . From 1910-1920 the price index rose from 1.1 to 2.2, while in 1990-2000 14.7 to 19.6. Which decade shows greater price inflation? The line chart deceptively makes it seem like it was the 90s. But, really prices doubled (100% increase) in the 1910s, while it only rose 33% in the 1990s.
3. The main reason the bottom 40% are in this quandary, is due to market liberalization, as more and more share went to top 1%, less went to them. That wasn't always the case, from 1933-1973 the average income of the bottom 90% beat inflation by 400%.
Saturday, September 17, 2011
Why the Federal government should never run a budget surplus?
In an earlier post I covered why the US Federal government should never run a budget surplus, unless there is an offsetting trade surplus. And given that the US runs a large trade deficit, a budget surplus would indeed be harmful. Let me address this topic again in the simplest possible terms. For more details and policy proposals and spending constraints see the original post.
The thing to remember throughout is that a sovereign currency issuer like the US, doesn't face a solvency constraint, i.e: we are not going to run out of dollars. The constraint for government spending is not solvency but inflation. This is covered more in the earlier post.
Why not a budget surplus?
If I give you $20, and you give me $15, you are now financially wealthier by $5, everyone can agree on that. It doesn't matter whether a real good/service was bought/sold or not, as far as financial assets (such as cash, deposits etc:) are concerned, the outcome is the same, you are financially wealthier by $5. If that one transaction is all that you engage in for a given year, you can think of the $15 as your spending for the year, while the $20 is your gross income. Your income less spending is $5. Obviously, your financial position is better off (by $5) at the end of the year. The same also holds true at the macro level, let us take a look at government budget deficits/surpluses to demonstrate this.
We obviously have a budget deficit when the federal government spends more than it taxes. Let us say taxes are $2 Trillion, while government spending is $3.5T, then the government deficit is $1.5T. So where does this extra $1.5T go, does it disappear into thin air as some believe? For simplicity, if we assume for now, the foreign trade balance is 0 (exports equals imports), then every single one of those government deficit dollars ends up in the domestic private sector. In other words the government budget deficit, to the penny, can be thought of as net income for the domestic private sector as a whole.
The deficit spending may be income for an additional federal govt. employee. It may be an additional firefighter or teacher's salary, via a transfer to a state government. It may be income for a private construction worker hired to repair the nation's ailing bridges. It may be retained earnings for a business which provides services to the government. It may be dividends to the investors of that business. It maybe in the form of a tax cut for lower income folks. Or it maybe even wasted on bank bailouts.[1]
Given that inflow is larger than outflow by $1.5T, domestic private sector net financial wealth (financial assets minus debts) as a whole rises by $1.5T.[2] This is not rocket science, it is no different than if I give you $20, and you give me $15, you are now financially wealthier by $5. Similarly, when the government spends $1.5 trillion on top of what it takes out in taxes, domestic private sector net financial wealth (as a whole) rises by $1.5T. Where else can the money ago? To the residents of planet Vulcan? Any spending within the private sector just transfers financial wealth within the sector. If you buy a $500 Dell computer, you are financially poorer by $500, while Dell, its employees, investors, suppliers etc: are financially richer by $500. Total private sector net financial wealth has not changed. It just moved within the private sector.
Guess what happens when the government runs a budget surplus. Let us say taxes are $3 Trillion, while government spending is $2.5T, then the budget surplus is $500 Billion. In our example this would be like if I give you $20, and you give me $25, you are now financially poorer by $5. The government is literally taking more out of the domestic sector than it is putting back in. A $500B subtraction to private sector net financial wealth (as a whole). If the budget surplus continues for an extended period, the private sector is literally being depleted.
This is unsustainable. In the entire history of the US there were only 5 periods in which we had 5+ years of government budget surpluses. As economist Randall Wray points out, each one was followed by a depression. The last extended surplus years were 1920-29, where we reduced government debt by 33%. Guess what followed, the Great Depression. Am I saying that the budget surplus was the cause of the depression? No, but it certainly doesn't help, as the private sector would be net borrowing (in deficit) if it is to keep up the same level of spending, when the government budget is in surplus. Actually, it is far more likely that the causation is reverse, a private debt binge is reflected in the government budget as a surplus.[3] The point is that sectors always balance. If the private sector does decide to reduce its debt fueled spending (which is bound to happen eventually), then GDP falls, given that GDP is total spending. As a consequence total income falls due to the fact the someone's spending is someone else's income. And now we have a recession.
On a quick note, I often hear people say, what about government debt issuance? Isn't that a flow out of the private sector, that balances the deficit inflow? Then I say, are you saying buying $100K of treasuries decreases your net financial wealth by $100K? No of course not, it is a financial asset swap. If you move your money from a checking account to a bank CD does your total financial assets fall? Buying a treasury is just like buying a CD, it is in you asset column. Your net financial wealth hasn't changed, only the composition of your asset portfolio has changed.
US Sectoral Financial Balances
So far we addressed a hypothetical situation where the foreign trade balance is zero. In the case of the USA, we do have a trade deficit (imports > exports), hence in reality a significant portion of dollars ends up overseas also. Does anyone think it is coincidence that the two countries (China & Japan) with which we have the largest trade deficits also have the largest dollar holdings in the form of treasuries? In the the real world, the federal government deficit increases the net financial wealth of the domestic private sector, provided it is not offset by a trade deficit. In our original example where the trade balance is zero the domestic private sector balance equals the government deficit as we would expect.
For those who are not familiar with the term Current Account, it is mostly the foreign trade balance (exports - imports). It also consists of net factor income. For more details on terms see here. The domestic private sector consists of households, firms and financial firms and its balance is the addition/subtraction to net financial wealth of the private sector in a given period. If the private sector is net borrowing (in deficit), then its balance will be negative; if it is net saving (in surplus), then its balance will be positive.
Economist Scott Fullwiler has compiled actual financial balances of each sector from US national accounts. See figure below. See here for actual examples from US national accounts- see footnotes 1, 3 and 5 in that post for source data. Notice the formula always holds true. Notice how during the late 90s as the government runs a budget surplus and the current account is in deficit (negative), the private sector balance (as a whole) is in deficit for the first time. The same happens during much of the 2000s as the government budget deficit was not large enough to offset the large current account deficit.[3] A private sector deficit is a subtraction to private sector net financial wealth.
Why does this hold?
For an explanation see economist Stephanie Kelton's article here and here. For an advanced version see this article by economist Scott Fullwiler. For the general reader, I will use a simple example to illustrate this. This is not an explanation, just an illustration...
Let us say we have 3 people Alice, Jim and Bob. Each starts out with net financial wealth of $500. Note the keyword NET, Jim may have $2000 of financial assets, and debt of $1500, in which case his net financial wealth is still $500. Also note the keyword FINANCIAL we are only referring to financial assets (such as cash, deposits, stocks etc:). Real assets (such as houses, cars etc:) are not included in the calculation. They engage in 3 transactions during a period of time...
Transaction 1: Alice buys eggs from Jim for $10. Obviously now Alice is down $10, while Jim is up $10. The sum of the balances is ZERO. This is just a fancy way of saying if Alice gives Jim $10, then Alice doesn't have $10 anymore. Alice's net financial wealth falls by $10, while Jim's rises by $10. The total net financial wealth of the system ($1500) hasn't changed as we would expect, given that sum of the balances is zero. $10 of financial wealth transferred from Alice to Jim.
Transaction 2: Bob buys bread from Alice for $20. Bob, now is down $20 (his balance is in deficit), while Alice's balance which was in in deficit of $10 after transaction 1, is up $20, so now she has a surplus of $10. Jim's balance remains at a surplus of $10. Once again the sum of the balances of all three is ZERO, not exactly rocket science here.
Transaction 3: Jim buys plumbing service from Bob for $40. Yup still ZERO.
After 3 transactions, Alice and Bob now have a positive balance (surplus) of $10 and $20 respectively, while Jim has a negative balance (deficit) of the exact same amount as the total surplus in the system $30. For any single entity to run a surplus, the sum total of the rest in the system must run a deficit of the same amount. In other words the balances always sum to ZERO, after each transaction, and you can see that in the 'total' column for each row. The total financial net wealth never changes, it still remains $1500. Ever wonder why we have double-entry accounting? For every credit, there must be an equal debit somewhere else, for balances to sum to zero. Anyway in our example...
Now try this same exercise with 50 people, the sum of the balances for all entities after any given period must equal ZERO. Now try this with groups of people, say 3 corporations, it still works. We are just dealing with millions of dollars now. Now let us form three all encompassing groups. The government sector, the private sector and the foreign sector. This still holds, and real world data confirms the prediction.
If the foreign sector has a surplus, that is the same as a current account deficit from our perspective, so negative foreign sector balance, is positive current account balance. And obviously negative government balance is the same as the government deficit.
Update: The main difference is that Alice, Jim and Bob cannot create new dollars when they spend. The US government as the sovereign issuer of the dollar, creates new dollars when it deficit spends. It can run perpetual deficits, and it has in the past. In the entire history of the US there has only been 5 periods, where we had 5+ continuous years of government budget surpluses. From 1946 to 1981 when we reduced the debt/GDP from 121% to 32%, guess how many surplus years we had? Just 5 surplus (barely) years in total. As you can see in Fig 1, the red line rarely crosses into positive territory. Solvency is not a constraint for currency issuers, inflation is the only constraint.
Conclusions
The sum of sectoral financial balances always equal ZERO. If the government runs a budget surplus, without an offsetting current account surplus, then the private sector as a whole is running a deficit, i.e they are net borrowing and hence this is a subtraction to their net financial wealth. A surplus of one sector must result in a deficit for another.
So when the private sector attempts to net save (run a surplus) as in the current recession, the federal government should be accommodating and run an appropriate budget deficit. Some of this will happen naturally due to reduced tax revenues and increase in the automatic stabilizers (such as unemployment insurance). Any attempts at fiscal austerity (trying to balance the budget) while the private sector wishes to save will not end well. Two sectors cannot net save at the same time (depending on the foreign sector balance of course) as sectoral financials have to balance.
If both sectors attempt to net save, that is if the government doesn't pick up the slack for loss of private sector spending, there is obviously now less spending overall in the economy (saving is defined as not spending in economics). Less spending means GDP falls, and as a consequence income falls and the recession worsens. And of course now the sectors balance at a lower GDP level. Since income falls, taxes fall and ironically the government deficit actually gets worse, when the budget cuts are attempted. This is what we are seeing with Ireland and Greece.
The sectoral financial balances model is not rocket science, it is not any more complicated then if I give you $20, then I don't have $20, you have it. What applies for individuals also applies to sectors also. But yet this still has not made much inroads into mainstream economics, although that is slowly changing now. The experiences of countries like Ireland and Greece shows the prescription of mainstream economics, government fiscal austerity, is downright disastrous. Just in Q2 2011 Greece's GDP was falling at an annualized rate of 7.0%. The last chart shows that the government budget cuts starting in 2010 have been the biggest drag on GDP. But yet the calls for budget cuts continue in the Eurozone officialdom. Unless this course is reversed this is unlikely to end well.
Not a single person running our government seems to understand this basic fact as well. The airwaves are saturated with talk about balancing the government budget, when it is not even close to being an issue. It is not even necessary to run a budget surplus to reduce our debt to GDP ratio. The real issue is excessive private debt. When was the last time we heard about that from the congressional talking heads. We hear talk about balancing the budget from even the most liberal faction of Congress (although to be fair, at least they are talking about balancing down the road not in the middle of the recession).[4]. Running an economy based on faith based beliefs, rather than facts is bound to be disastrous.
Updated 9/21/2011: Reorganized things a bit
Updated 3/20/2012: Moved some notes up to the article
Update 4/9/2012: Fixed broken links,fixed some errors
Notes
1. Not all government deficit spending is created equally. Some are more efficient than others. A bank bailout is one of the most inefficient way of spending government resources.
2. Note the key word financial we are only talking about financial assets (such as cash, checking deposits, stocks etc:) in the above examples. Real assets (such as houses, cars etc:) are not included. Financial transactions are a ZERO sum game from a global perspective for users of a currency, that is what we are trying to show here.
3. Or the causation maybe that the private sector gets itself into debt, the sectors balance and the government budget is in surplus, that is more likely. Either way the sectors always balance. The private sector could have chosen to reduce its debt fueled spending, and if another sector doesn't pick up the slack, then GDP falls and the sectors balance at a lower level of GDP, but that is not what happened (except for the 2000 recession). This is what is happening now, the private sector is trying to pare it is debt burden. While the government did pick up some slack, it was only enough for a small growth in GDP. Which, by the way is fading as the government cuts its budget.
4. Update 9/19: 30% of the deficit is due to the recession alone, given that there is less tax revenue and more social safety net spending. The best way to cut the deficit ($4T in 10 yrs) is to do nothing at all with the deficit, get to full employment as fast as possible. But if you must cut it now, best to do it it in a way that impacts the least amount of spending. For example, richer people save rather than spend much of their income, so raising their taxes is less likely to impact GDP that much.
The thing to remember throughout is that a sovereign currency issuer like the US, doesn't face a solvency constraint, i.e: we are not going to run out of dollars. The constraint for government spending is not solvency but inflation. This is covered more in the earlier post.
Why not a budget surplus?
If I give you $20, and you give me $15, you are now financially wealthier by $5, everyone can agree on that. It doesn't matter whether a real good/service was bought/sold or not, as far as financial assets (such as cash, deposits etc:) are concerned, the outcome is the same, you are financially wealthier by $5. If that one transaction is all that you engage in for a given year, you can think of the $15 as your spending for the year, while the $20 is your gross income. Your income less spending is $5. Obviously, your financial position is better off (by $5) at the end of the year. The same also holds true at the macro level, let us take a look at government budget deficits/surpluses to demonstrate this.
We obviously have a budget deficit when the federal government spends more than it taxes. Let us say taxes are $2 Trillion, while government spending is $3.5T, then the government deficit is $1.5T. So where does this extra $1.5T go, does it disappear into thin air as some believe? For simplicity, if we assume for now, the foreign trade balance is 0 (exports equals imports), then every single one of those government deficit dollars ends up in the domestic private sector. In other words the government budget deficit, to the penny, can be thought of as net income for the domestic private sector as a whole.
The deficit spending may be income for an additional federal govt. employee. It may be an additional firefighter or teacher's salary, via a transfer to a state government. It may be income for a private construction worker hired to repair the nation's ailing bridges. It may be retained earnings for a business which provides services to the government. It may be dividends to the investors of that business. It maybe in the form of a tax cut for lower income folks. Or it maybe even wasted on bank bailouts.[1]
Given that inflow is larger than outflow by $1.5T, domestic private sector net financial wealth (financial assets minus debts) as a whole rises by $1.5T.[2] This is not rocket science, it is no different than if I give you $20, and you give me $15, you are now financially wealthier by $5. Similarly, when the government spends $1.5 trillion on top of what it takes out in taxes, domestic private sector net financial wealth (as a whole) rises by $1.5T. Where else can the money ago? To the residents of planet Vulcan? Any spending within the private sector just transfers financial wealth within the sector. If you buy a $500 Dell computer, you are financially poorer by $500, while Dell, its employees, investors, suppliers etc: are financially richer by $500. Total private sector net financial wealth has not changed. It just moved within the private sector.
Guess what happens when the government runs a budget surplus. Let us say taxes are $3 Trillion, while government spending is $2.5T, then the budget surplus is $500 Billion. In our example this would be like if I give you $20, and you give me $25, you are now financially poorer by $5. The government is literally taking more out of the domestic sector than it is putting back in. A $500B subtraction to private sector net financial wealth (as a whole). If the budget surplus continues for an extended period, the private sector is literally being depleted.
This is unsustainable. In the entire history of the US there were only 5 periods in which we had 5+ years of government budget surpluses. As economist Randall Wray points out, each one was followed by a depression. The last extended surplus years were 1920-29, where we reduced government debt by 33%. Guess what followed, the Great Depression. Am I saying that the budget surplus was the cause of the depression? No, but it certainly doesn't help, as the private sector would be net borrowing (in deficit) if it is to keep up the same level of spending, when the government budget is in surplus. Actually, it is far more likely that the causation is reverse, a private debt binge is reflected in the government budget as a surplus.[3] The point is that sectors always balance. If the private sector does decide to reduce its debt fueled spending (which is bound to happen eventually), then GDP falls, given that GDP is total spending. As a consequence total income falls due to the fact the someone's spending is someone else's income. And now we have a recession.
On a quick note, I often hear people say, what about government debt issuance? Isn't that a flow out of the private sector, that balances the deficit inflow? Then I say, are you saying buying $100K of treasuries decreases your net financial wealth by $100K? No of course not, it is a financial asset swap. If you move your money from a checking account to a bank CD does your total financial assets fall? Buying a treasury is just like buying a CD, it is in you asset column. Your net financial wealth hasn't changed, only the composition of your asset portfolio has changed.
US Sectoral Financial Balances
So far we addressed a hypothetical situation where the foreign trade balance is zero. In the case of the USA, we do have a trade deficit (imports > exports), hence in reality a significant portion of dollars ends up overseas also. Does anyone think it is coincidence that the two countries (China & Japan) with which we have the largest trade deficits also have the largest dollar holdings in the form of treasuries? In the the real world, the federal government deficit increases the net financial wealth of the domestic private sector, provided it is not offset by a trade deficit. In our original example where the trade balance is zero the domestic private sector balance equals the government deficit as we would expect.
Domestic Private Sector Balance = Government Deficit + Current Account Balance
For those who are not familiar with the term Current Account, it is mostly the foreign trade balance (exports - imports). It also consists of net factor income. For more details on terms see here. The domestic private sector consists of households, firms and financial firms and its balance is the addition/subtraction to net financial wealth of the private sector in a given period. If the private sector is net borrowing (in deficit), then its balance will be negative; if it is net saving (in surplus), then its balance will be positive.
Economist Scott Fullwiler has compiled actual financial balances of each sector from US national accounts. See figure below. See here for actual examples from US national accounts- see footnotes 1, 3 and 5 in that post for source data. Notice the formula always holds true. Notice how during the late 90s as the government runs a budget surplus and the current account is in deficit (negative), the private sector balance (as a whole) is in deficit for the first time. The same happens during much of the 2000s as the government budget deficit was not large enough to offset the large current account deficit.[3] A private sector deficit is a subtraction to private sector net financial wealth.
 |
| Fig 1: US Sectoral Financial Balances (from Scott Fullwiler) Note: the red line in the chart is shown as positive since the label is Govt. deficit (i.e: negative Govt. balance) |
Why does this hold?
For an explanation see economist Stephanie Kelton's article here and here. For an advanced version see this article by economist Scott Fullwiler. For the general reader, I will use a simple example to illustrate this. This is not an explanation, just an illustration...
Let us say we have 3 people Alice, Jim and Bob. Each starts out with net financial wealth of $500. Note the keyword NET, Jim may have $2000 of financial assets, and debt of $1500, in which case his net financial wealth is still $500. Also note the keyword FINANCIAL we are only referring to financial assets (such as cash, deposits, stocks etc:). Real assets (such as houses, cars etc:) are not included in the calculation. They engage in 3 transactions during a period of time...
Transaction 1: Alice buys eggs from Jim for $10. Obviously now Alice is down $10, while Jim is up $10. The sum of the balances is ZERO. This is just a fancy way of saying if Alice gives Jim $10, then Alice doesn't have $10 anymore. Alice's net financial wealth falls by $10, while Jim's rises by $10. The total net financial wealth of the system ($1500) hasn't changed as we would expect, given that sum of the balances is zero. $10 of financial wealth transferred from Alice to Jim.
Transaction 2: Bob buys bread from Alice for $20. Bob, now is down $20 (his balance is in deficit), while Alice's balance which was in in deficit of $10 after transaction 1, is up $20, so now she has a surplus of $10. Jim's balance remains at a surplus of $10. Once again the sum of the balances of all three is ZERO, not exactly rocket science here.
Transaction 3: Jim buys plumbing service from Bob for $40. Yup still ZERO.
 |
| Fig 2: Financial Balances |
After 3 transactions, Alice and Bob now have a positive balance (surplus) of $10 and $20 respectively, while Jim has a negative balance (deficit) of the exact same amount as the total surplus in the system $30. For any single entity to run a surplus, the sum total of the rest in the system must run a deficit of the same amount. In other words the balances always sum to ZERO, after each transaction, and you can see that in the 'total' column for each row. The total financial net wealth never changes, it still remains $1500. Ever wonder why we have double-entry accounting? For every credit, there must be an equal debit somewhere else, for balances to sum to zero. Anyway in our example...
Alice Bal + Bob Bal + Jim Bal = 0
Now try this same exercise with 50 people, the sum of the balances for all entities after any given period must equal ZERO. Now try this with groups of people, say 3 corporations, it still works. We are just dealing with millions of dollars now. Now let us form three all encompassing groups. The government sector, the private sector and the foreign sector. This still holds, and real world data confirms the prediction.
Government Bal + Private Sector Bal + Foreign Sector Bal = 0
Private Sector Bal = -Government Bal - Foreign Sector Bal
If the foreign sector has a surplus, that is the same as a current account deficit from our perspective, so negative foreign sector balance, is positive current account balance. And obviously negative government balance is the same as the government deficit.
Private Sector Bal = Government Deficit + Current Account Bal
Update: The main difference is that Alice, Jim and Bob cannot create new dollars when they spend. The US government as the sovereign issuer of the dollar, creates new dollars when it deficit spends. It can run perpetual deficits, and it has in the past. In the entire history of the US there has only been 5 periods, where we had 5+ continuous years of government budget surpluses. From 1946 to 1981 when we reduced the debt/GDP from 121% to 32%, guess how many surplus years we had? Just 5 surplus (barely) years in total. As you can see in Fig 1, the red line rarely crosses into positive territory. Solvency is not a constraint for currency issuers, inflation is the only constraint.
Conclusions
The sum of sectoral financial balances always equal ZERO. If the government runs a budget surplus, without an offsetting current account surplus, then the private sector as a whole is running a deficit, i.e they are net borrowing and hence this is a subtraction to their net financial wealth. A surplus of one sector must result in a deficit for another.
So when the private sector attempts to net save (run a surplus) as in the current recession, the federal government should be accommodating and run an appropriate budget deficit. Some of this will happen naturally due to reduced tax revenues and increase in the automatic stabilizers (such as unemployment insurance). Any attempts at fiscal austerity (trying to balance the budget) while the private sector wishes to save will not end well. Two sectors cannot net save at the same time (depending on the foreign sector balance of course) as sectoral financials have to balance.
If both sectors attempt to net save, that is if the government doesn't pick up the slack for loss of private sector spending, there is obviously now less spending overall in the economy (saving is defined as not spending in economics). Less spending means GDP falls, and as a consequence income falls and the recession worsens. And of course now the sectors balance at a lower GDP level. Since income falls, taxes fall and ironically the government deficit actually gets worse, when the budget cuts are attempted. This is what we are seeing with Ireland and Greece.
The sectoral financial balances model is not rocket science, it is not any more complicated then if I give you $20, then I don't have $20, you have it. What applies for individuals also applies to sectors also. But yet this still has not made much inroads into mainstream economics, although that is slowly changing now. The experiences of countries like Ireland and Greece shows the prescription of mainstream economics, government fiscal austerity, is downright disastrous. Just in Q2 2011 Greece's GDP was falling at an annualized rate of 7.0%. The last chart shows that the government budget cuts starting in 2010 have been the biggest drag on GDP. But yet the calls for budget cuts continue in the Eurozone officialdom. Unless this course is reversed this is unlikely to end well.
Not a single person running our government seems to understand this basic fact as well. The airwaves are saturated with talk about balancing the government budget, when it is not even close to being an issue. It is not even necessary to run a budget surplus to reduce our debt to GDP ratio. The real issue is excessive private debt. When was the last time we heard about that from the congressional talking heads. We hear talk about balancing the budget from even the most liberal faction of Congress (although to be fair, at least they are talking about balancing down the road not in the middle of the recession).[4]. Running an economy based on faith based beliefs, rather than facts is bound to be disastrous.
Updated 9/21/2011: Reorganized things a bit
Updated 3/20/2012: Moved some notes up to the article
Update 4/9/2012: Fixed broken links,fixed some errors
Notes
1. Not all government deficit spending is created equally. Some are more efficient than others. A bank bailout is one of the most inefficient way of spending government resources.
2. Note the key word financial we are only talking about financial assets (such as cash, checking deposits, stocks etc:) in the above examples. Real assets (such as houses, cars etc:) are not included. Financial transactions are a ZERO sum game from a global perspective for users of a currency, that is what we are trying to show here.
3. Or the causation maybe that the private sector gets itself into debt, the sectors balance and the government budget is in surplus, that is more likely. Either way the sectors always balance. The private sector could have chosen to reduce its debt fueled spending, and if another sector doesn't pick up the slack, then GDP falls and the sectors balance at a lower level of GDP, but that is not what happened (except for the 2000 recession). This is what is happening now, the private sector is trying to pare it is debt burden. While the government did pick up some slack, it was only enough for a small growth in GDP. Which, by the way is fading as the government cuts its budget.
4. Update 9/19: 30% of the deficit is due to the recession alone, given that there is less tax revenue and more social safety net spending. The best way to cut the deficit ($4T in 10 yrs) is to do nothing at all with the deficit, get to full employment as fast as possible. But if you must cut it now, best to do it it in a way that impacts the least amount of spending. For example, richer people save rather than spend much of their income, so raising their taxes is less likely to impact GDP that much.
Tuesday, September 6, 2011
Is US government debt a burden on our grand children
You hear this a lot these days from deficit hawks. Our current government deficit spending, will result in a higher future tax burden. So better cut back on the debt now, for the sake of our grandchildren. It is as if these people forget how fractions work - Debt/GDP. Debt by itself means nothing, it only has meaning as a percentage of income. Remember that, US GDP equals all gross domestic income made in the US, given that someone's spending is someone else's income. Thus US debt/US GDP is the relevant figure here. It is as if the hawks assume the denominator (income) will be static forever. Only if GDP is static. What is really static over time is the numerator - debt principal and interest payments. As GDP and inflation grows over time, the original debt remains the same, that is a certainty. So what happens when GDP is higher, income will also be higher (since GDP is income) and thus tax payments will also be higher, all without any new tax increases[1]. So even by their misguided logic, you will have more taxes to cover the same debt (which never changes over time), plus more for new debt issuance. Is there a need for an increased tax burden, in this scenario?
US Debt/GDP history
Take a look at the experience of the US after WWII (1946-1981). Debt/GDP ratio was 121% in 1946, but by 1981 it was just 32%. You would think the Government paid down a lot of its debt. In reality not one cent was paid off. It quadrupled from $271B to $994B. Its not like the government stopped issuing debt after 1946. But yet the debt/GDP ratio went down, because GDP growth far outstripped debt growth. Yet during the same period, the tax burden remained roughly the same, averaging around 17-18% of income (GDP). This idea that the US government is just like a household has to be jettisoned for good. The government does not need to ever repay its debt, it outgrows it. It has only been paid back once (in 1837), but then a depression followed and the government has been in debt ever since. How many households can do that and still function? Does it really matter (even by conventional logic) that the government debt is $100T 30 years from now, when GDP is $200T?
Austerity hurts
You know what really hurts your grand children. Its not US debt, it is austerity (lack of GDP growth, due to government budget cuts). Generally a recession happens when consumer spending (C) and private investment (I) falls due to loss of confidence in the economy, in this case due to the collapse of the housing bubble. As C and I are components of GDP, GDP falls, and income falls as as a consequence. Less income among the same number of people, and guess what, some people finds themselves out of work[2]. Government spending (G), which is also a component of GDP should rise to prevent a collapse in GDP. Thus, government debt will also rise. Some of this increased spending happens automatically, as social safety net spending increases (unemployment insurance, social security etc:). This may not be enough, ideally the increase should compensate for the loss in C and I[3]. Yes the numerator (debt) increases rapidly for sometime, but GDP growth catches up far faster than if we had chosen the austerity path. Austerity is a double whammy. When the government cuts spending (G) in a recession, not only does GDP fall, but ironically the debt also rises . Why, because GDP is income, and when income falls, taxes fall, unemployment insurance payments rise, thus actually increasing the government debt. The experience of countries like Ireland who embraced austerity early on should show that trying to cut government debt in a recession actually increases the debt. Looks like the US is slowly heading in the Irish direction.
So far I explored this with mainstream logic. The mainstream assumption is that taxes fund government spending. In the case of a state government yes, in the case of a national government under the Euro regime, yes. But for a sovereign issuer of currency, under a floating exchange regime, no. Why does the issuer of dollars, who can create them at will, need to acquire dollars to make payments in dollars? In this type of government (US, Japan, Canada etc:) taxes are a form of inflation control[4], not government income. Yes currently there are restrictions on how the government spends, but they are a self imposed political straight jacket, they are certainly not economic in nature. They should be repealed so we can unleash the full potential of our economy. The title claim makes even less sense, when you take this into context. The only real economic restriction on government spending is inflation.[5] Plus lets us not forget that a liability (government debt), is in an asset to some one else. 69% of US government debt is owned by American households and institutions. If you own treasuries they are your assets not your debt. So if anything your grand children are inheriting interest paying assets not debt.
Notes:
1. I made things a little simpler so it is easy to follow. See the Question 5 section here for more detail, on why government budget surpluses are not needed to reduce the debt ratio.
2. Again I simplified things slightly. For more detail on recessions see here.
3. Not all government spending is created equal. Some spending is very inefficient, such as tax cuts for rich, or giving tax cuts to business and hope they hire people. On the other hand direct government spending on creating jobs is far more efficient. While the modest US stimulus of 2009 did help in GDP growth when it was still active, it didn't help as much (it still helped) in lowering the unemployment situation. It was far too small and contained too much inefficient spending. Direct government spending on jobs has not been tried since the 1930s when it was highly successful. The GDP growth rate then, averaged 10% and employment growth was 750k jobs/month (population adjusted).
4. In this example I am referring to possible inflation due to government deficit spending. There are different types of inflation. For example supply issues, caused by real shortages or speculation. The latter type of inflation is what is occurring now in the energy and food markets.
5. There is a range beyond which government spending will cause more than the desired inflation. This range is much wider in recessionary times, while it is much narrower at times of full employment. But in no way is the money supply proportional to price inflation. It maybe during times of full employment, but otherwise unlikely.
US Debt/GDP history
Take a look at the experience of the US after WWII (1946-1981). Debt/GDP ratio was 121% in 1946, but by 1981 it was just 32%. You would think the Government paid down a lot of its debt. In reality not one cent was paid off. It quadrupled from $271B to $994B. Its not like the government stopped issuing debt after 1946. But yet the debt/GDP ratio went down, because GDP growth far outstripped debt growth. Yet during the same period, the tax burden remained roughly the same, averaging around 17-18% of income (GDP). This idea that the US government is just like a household has to be jettisoned for good. The government does not need to ever repay its debt, it outgrows it. It has only been paid back once (in 1837), but then a depression followed and the government has been in debt ever since. How many households can do that and still function? Does it really matter (even by conventional logic) that the government debt is $100T 30 years from now, when GDP is $200T?
 |
| US Debt as % of GDP (zfacts.com) |
Austerity hurts
You know what really hurts your grand children. Its not US debt, it is austerity (lack of GDP growth, due to government budget cuts). Generally a recession happens when consumer spending (C) and private investment (I) falls due to loss of confidence in the economy, in this case due to the collapse of the housing bubble. As C and I are components of GDP, GDP falls, and income falls as as a consequence. Less income among the same number of people, and guess what, some people finds themselves out of work[2]. Government spending (G), which is also a component of GDP should rise to prevent a collapse in GDP. Thus, government debt will also rise. Some of this increased spending happens automatically, as social safety net spending increases (unemployment insurance, social security etc:). This may not be enough, ideally the increase should compensate for the loss in C and I[3]. Yes the numerator (debt) increases rapidly for sometime, but GDP growth catches up far faster than if we had chosen the austerity path. Austerity is a double whammy. When the government cuts spending (G) in a recession, not only does GDP fall, but ironically the debt also rises . Why, because GDP is income, and when income falls, taxes fall, unemployment insurance payments rise, thus actually increasing the government debt. The experience of countries like Ireland who embraced austerity early on should show that trying to cut government debt in a recession actually increases the debt. Looks like the US is slowly heading in the Irish direction.
So far I explored this with mainstream logic. The mainstream assumption is that taxes fund government spending. In the case of a state government yes, in the case of a national government under the Euro regime, yes. But for a sovereign issuer of currency, under a floating exchange regime, no. Why does the issuer of dollars, who can create them at will, need to acquire dollars to make payments in dollars? In this type of government (US, Japan, Canada etc:) taxes are a form of inflation control[4], not government income. Yes currently there are restrictions on how the government spends, but they are a self imposed political straight jacket, they are certainly not economic in nature. They should be repealed so we can unleash the full potential of our economy. The title claim makes even less sense, when you take this into context. The only real economic restriction on government spending is inflation.[5] Plus lets us not forget that a liability (government debt), is in an asset to some one else. 69% of US government debt is owned by American households and institutions. If you own treasuries they are your assets not your debt. So if anything your grand children are inheriting interest paying assets not debt.
Notes:
1. I made things a little simpler so it is easy to follow. See the Question 5 section here for more detail, on why government budget surpluses are not needed to reduce the debt ratio.
2. Again I simplified things slightly. For more detail on recessions see here.
3. Not all government spending is created equal. Some spending is very inefficient, such as tax cuts for rich, or giving tax cuts to business and hope they hire people. On the other hand direct government spending on creating jobs is far more efficient. While the modest US stimulus of 2009 did help in GDP growth when it was still active, it didn't help as much (it still helped) in lowering the unemployment situation. It was far too small and contained too much inefficient spending. Direct government spending on jobs has not been tried since the 1930s when it was highly successful. The GDP growth rate then, averaged 10% and employment growth was 750k jobs/month (population adjusted).
4. In this example I am referring to possible inflation due to government deficit spending. There are different types of inflation. For example supply issues, caused by real shortages or speculation. The latter type of inflation is what is occurring now in the energy and food markets.
5. There is a range beyond which government spending will cause more than the desired inflation. This range is much wider in recessionary times, while it is much narrower at times of full employment. But in no way is the money supply proportional to price inflation. It maybe during times of full employment, but otherwise unlikely.
Friday, August 5, 2011
Why US government debt is not debt Part 2
Few day ago I posted on why US government debt is not debt? I wanted to add a couple of things. At no point along the chain from your purchase of a Chinese good to China's purchase of treasuries does anyone ship wheelbarrows full of cash to China. This all happens electronically within the banking system. The nature of money is to function as a valueless token that facilitates the exchange of real goods and services. We think of money as a physical thing with value, but it is just pieces of papers with dead presidents on them. Only paper and metal money existed in the past, due to technological limitations. But today, most money exists only as digital entries in bank data centers. Think how much of your financial wealth exists in physical form? Unless you are a mattress stuffee, perhaps just the dollars in your wallet. The rest, the lion share, exist only as entries in bank databases. There is nothing wrong with this system, as long as there is proper accounting and transparency. The advantage is electronic dollar tokens makes day to day transactions very convenient and efficient. Which is more convenient and efficient - snail mail or email? Same applies for physical vs digital money.
So when you buy a $100 Chinese product with your debit card, your bank account is electronically deducted by $100 while the Chinese company's bank account is credited by $100. The end result is that, two database entries change in opposite directions at the respective banking data centers. Your account database entry by -$100, the Chinese company's by +$100. That's really it, there are no physical transfers. It is like a score keeping system, where dollars are like points. Same at the other end of the chain. When China buy $10B of treasuries, its reserve account at the Fed (checking account) is deducted by $10B and its treasury account is credited by $10B. That's it, two numbers changed in opposite directions at the US government data centers.
As an analogy, think of what happens when you transfer $1000 from your checking account to purchase a CD. Once again two entries change in opposite directions,. The $1000 is locked up for a period of time in the CD, but it earns interest in return. This is similar to what happens when China buys treasuries. Now here is the question when you transferred money from checking to the CD did the bank get more money?
Now what happens when the treasury bond matures? China's treasury account is deducted by $10B and its reserve account is credited by $10B. All the US government has to do is once again update two entries in opposite directions. Being the issuer of the currency in which the debt is issued, there is no limit to the amount which the government can credit bank accounts in that currency. On the other hand a currency user (which is every one else) needs to have money coming in before it can go out. There is no economic reason by which the US will fail to make a payment. All it does is update numbers in a database. If it does issue a check, then the updates happens when the receiver deposits the check. Really the only way the US government could fail to make a payment is for voluntarily self-imposed political reasons.
The advantages of sovereign currency issuance
There are many reasons why it is advantageous, that our government is a sovereign issuer of currency.. One is that we don't want to end up like Greece, susceptible to the mercy of the bond markets. Greece doesn't have it own currency, so it really does rely on the bond markets for operating funds. It is like a state government in the US. Its 10yr bonds have an yield of 15.24%, its 2 yr bonds are at 33.64%!! (an inverted yield curve). In other words Greece's borrowing costs are ridiculously high. The so called bond vigilantes are pummeling Greece, they view it as a sub prime borrower. Greece probably may have already defaulted if it doesn't keep getting bailed by the ECB (European Central Bank) the issuer of the Euro.
On the other hand, US 10 yr bonds are at 2.56% and 2 yrs bonds are at 0.29%. 10 yr bonds in Japan, with a debt to GDP ratio far higher than Greece, is even lower than the US at 1.01%. Its 2 yr bonds are at 0.14%. There is not going to be much bond vigilantism against a currency issuer, an entity than can create money out of thin air, that is unless the lobotomy party, err.. I mean the tea party gains power and prevents the Fed from acting. There is a saying in the bond markets, "Don't fight the Fed". Investor Cullen Roche has compiled a chart here, which shows there is high correlation between Fed policy and treasury yields. Even the 30 yr bonds show an 87% correlation. In other words, the US is not at the mercy of the bond markets, even given our self-imposed political straight jacket. The Fed may be incompetent at a lot of things, but controlling interest rates is something it does very well.
Additionally we established in Part 1, that even if not at single person buys US bonds, it doesn't matter. As the sole issuer of dollars, does the US really need to get dollar loans to make payment in dollars. Even with current political restrictions the Fed can buy/sell treasury bonds as needed to support policy, it just can't buy it directly from the treasury.
So what is the US bond market really then? It is a really safe place to put your savings. That is how the bond market seems to view it. Take a look this chart from Cullen Roche reprinted below. Even in the middle of last month's debt ceiling debacle the yield was dropping. The yield drops when demand for the bond increases, investors are willing to accept a lower yield for safety. Every time there is economic head winds, investors dump their equity holdings to rush for the safety of treasuries. And when the economic news is better, they tend to leave. Bond investors doesn't seem to concerned at all about US government debt level. Quite opposite what the political class tells us, isn't it. When in doubt follow the money, and this chart below from the Roche article says more than a thousand words. So now can we stop worrying about the debt and focus on jobs.
So when you buy a $100 Chinese product with your debit card, your bank account is electronically deducted by $100 while the Chinese company's bank account is credited by $100. The end result is that, two database entries change in opposite directions at the respective banking data centers. Your account database entry by -$100, the Chinese company's by +$100. That's really it, there are no physical transfers. It is like a score keeping system, where dollars are like points. Same at the other end of the chain. When China buy $10B of treasuries, its reserve account at the Fed (checking account) is deducted by $10B and its treasury account is credited by $10B. That's it, two numbers changed in opposite directions at the US government data centers.
As an analogy, think of what happens when you transfer $1000 from your checking account to purchase a CD. Once again two entries change in opposite directions,. The $1000 is locked up for a period of time in the CD, but it earns interest in return. This is similar to what happens when China buys treasuries. Now here is the question when you transferred money from checking to the CD did the bank get more money?
Now what happens when the treasury bond matures? China's treasury account is deducted by $10B and its reserve account is credited by $10B. All the US government has to do is once again update two entries in opposite directions. Being the issuer of the currency in which the debt is issued, there is no limit to the amount which the government can credit bank accounts in that currency. On the other hand a currency user (which is every one else) needs to have money coming in before it can go out. There is no economic reason by which the US will fail to make a payment. All it does is update numbers in a database. If it does issue a check, then the updates happens when the receiver deposits the check. Really the only way the US government could fail to make a payment is for voluntarily self-imposed political reasons.
The advantages of sovereign currency issuance
There are many reasons why it is advantageous, that our government is a sovereign issuer of currency.. One is that we don't want to end up like Greece, susceptible to the mercy of the bond markets. Greece doesn't have it own currency, so it really does rely on the bond markets for operating funds. It is like a state government in the US. Its 10yr bonds have an yield of 15.24%, its 2 yr bonds are at 33.64%!! (an inverted yield curve). In other words Greece's borrowing costs are ridiculously high. The so called bond vigilantes are pummeling Greece, they view it as a sub prime borrower. Greece probably may have already defaulted if it doesn't keep getting bailed by the ECB (European Central Bank) the issuer of the Euro.
On the other hand, US 10 yr bonds are at 2.56% and 2 yrs bonds are at 0.29%. 10 yr bonds in Japan, with a debt to GDP ratio far higher than Greece, is even lower than the US at 1.01%. Its 2 yr bonds are at 0.14%. There is not going to be much bond vigilantism against a currency issuer, an entity than can create money out of thin air, that is unless the lobotomy party, err.. I mean the tea party gains power and prevents the Fed from acting. There is a saying in the bond markets, "Don't fight the Fed". Investor Cullen Roche has compiled a chart here, which shows there is high correlation between Fed policy and treasury yields. Even the 30 yr bonds show an 87% correlation. In other words, the US is not at the mercy of the bond markets, even given our self-imposed political straight jacket. The Fed may be incompetent at a lot of things, but controlling interest rates is something it does very well.
Additionally we established in Part 1, that even if not at single person buys US bonds, it doesn't matter. As the sole issuer of dollars, does the US really need to get dollar loans to make payment in dollars. Even with current political restrictions the Fed can buy/sell treasury bonds as needed to support policy, it just can't buy it directly from the treasury.
So what is the US bond market really then? It is a really safe place to put your savings. That is how the bond market seems to view it. Take a look this chart from Cullen Roche reprinted below. Even in the middle of last month's debt ceiling debacle the yield was dropping. The yield drops when demand for the bond increases, investors are willing to accept a lower yield for safety. Every time there is economic head winds, investors dump their equity holdings to rush for the safety of treasuries. And when the economic news is better, they tend to leave. Bond investors doesn't seem to concerned at all about US government debt level. Quite opposite what the political class tells us, isn't it. When in doubt follow the money, and this chart below from the Roche article says more than a thousand words. So now can we stop worrying about the debt and focus on jobs.
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| Fig 1: CBOE Index that tracks 10yr treasury at 10 times yield (remember lower yield is better) |
Update 8/6: The S&P downgrade may or may not temporarily roil the bond market, no way to know how the hive mind (err.. market) will react, but in the end it should be a non-event. As some observers say, what should be more of a concern is whether there will be a domino effect into municipal bonds or foreign arenas. Downgrading a currency issuer, who's entire debt is in the same currency is meaningless. Japan has been downgraded many times but its yield on 10 yr bonds still remains low at 1.01%.
Monday, August 1, 2011
Why US government debt is not debt
First of all, treasuries are not your debt. If you own US treasuries they are in your asset column. You get interest if you own treasuries, you don't pay it, that much should be obvious. They are really your savings. Secondly, 69% of US "debt" is owned by American households and American institutions. 58% of the 69% (or 39% of the total) is owned by federal government agencies (the Social Security Administration etc:), i.e: money the government owes itself. Foreign ownership is just 31%. In other words most US treasury interest payments go to Americans. The debt is essentially money the government owes us, we don't owe anything to anybody. We hear jokes on how China is going to kneecap us if we don't pay up. Even if we hold the incorrect conventional view that US treasuries is debt, guess how much China owns - about 8%. Perhaps, we should be kneecapping ourselves. Japan owns about the same share as China, but you never hear about them "repossessing" America. All this type of debt talk is either outright ignorance or fear mongering plain and simple.
Is China lending to us
Essentially no, China's treasury holdings are a function of our trade deficit rather than our budget deficit. When you purchase Chinese goods, do you use dollars or Chinese currency? Dollars obviously. Given that we have a trade deficit with China, Chinese companies end up with excess dollars. Last quarter US exported $36B to China while China exported 650 CNY ($101B) to the US , Chinese companies as a whole have a net addition of 65B US dollars to their bank accounts. They can now use these dollars to buy dollar denominated assets such or US treasuries or US buildings , but then again you need two parties for a sale. Just because somebody wants to buy buildings doesn't mean they are for sale. In actuality what Chinese companies tend do is exchange dollars with the PBOC (Chinese central bank) for their own currency, and thus these dollars end up in China's reserve account (checking account) at the Fed. What will the PBOC do, sit on these dollars that earn no interest? Guess what they do, the vast majority of these dollars go into the purchase of treasuries that earn interest. See economist Randall Wray's post here for more details In Fig 1 from Prof. Wray's post notice how China's share of US treasuries increases as we run ever larger trade deficits with them in the 00's. Click to enlarge.
What should be clear now is that China's ownership of US treasuries is a function of the US trade deficit. Here is additional data. Does anyone think it is coincidence that the two countries with we have the largest trade deficits (China & Japan) have the largest foreign holdings of US treasuries at 47%? China can threaten all they want, but as long as they choose to run a trade surplus with us, they are going to end up with dollars. Sure they can buy US stocks instead of US treasuries, but historically they have not shown an appetite for that kind of risk[1].
Why US debt isn't debt
And given that the government is the issuer of currency, why is there even a need to issue debt? Let us say you had your own currency, that you could issue at will and it is accepted everywhere in exchange for goods and services. Will you ever fail to make a payment for lack of funds? What does debt mean in this case? Do you ever need to take on debt to make your payments? For households, state governments, business and even some European governments (in the Euro regime) like Greece, and even Germany, bond issuance is indeed debt, as they are currency users. But for a sovereign currency issuer like the US, Japan, Canada is bond issuance really debt?[2] Then what is it?
Debt issuance is gold standard relic, back from the 19th century, when economists lost the centuries old understanding of the nature of money, and decided to tie the output of the US economy to mines in South Africa. The gold standard is dead and gone for 40 years, but yet policymakers run the country as we are still in one. This is a completely unnecessary straight jacket in a modern fiat system. An issuer of money can never run out said money, solvency is never a restriction, thus the concept of debt is meaningless. The only real restriction on government spending, is inflation. That type of inflation is highly unlikely to happen right now, as we have high unemployment and large under utilization of productive capacity - in other words the metaphorical factories are sitting idle due to lack of demand for their products. Additional money injected (income) into the private sector right now, is far more likely to bring these metaphorical factories online than drive up prices.
Even though the US government doesn't have solvency restrictions, there are a lot of unnecessary political restrictions. They are political in nature, not economic. What we have is the worst of both worlds. A Fed that can issue money at will, and a Treasury which cannot. A Treasury which has accountability and transparency, and a Fed which has none. That is how you end up with a corrupt Fed chairman bailing out banks to the tune of $16T (yes trillion) behind closed doors. These kind of the things shouldn't happen if we are still to remain a democracy. The best of both worlds, would be a Fed and Treasury that have no restrictions in currency issuance with full transparency and accountability.
Why issue treasuries then
But that doesn't mean we should not issue treasuries. They do have other functions. For example the Fed exercises absolute control of the short term interest rate, and is willing to defend it with open market purchases/sales of treasuries. While there is market variability on the longer term treasury yields, that happens only because the Fed allows it. The Fed may choose to purchase a whole lot more of those treasuries in the open market, thus driving down yields. The Fed could purchase all of it, if there is not a single sale in the open market, as we established a currency issuer doesn't really to need to get its own currency from others. But there is no danger of that happening anytime soon, the demand for US treasuries generally exceed supply by 3:1 at treasury auctions. In addition, treasuries represent a risk free savings for the private sector. It is like a welfare program, as we established that the government doesn't really need your funds to operate. As Cullen Roche says the debt clock isn't really a debt clock, it is a national savings clock.
So in conclusion, we don't really have a debt problem. As a currency issuer, we are not going to fail to meet our debt payments, which by the way is in the same currency. We are not Greece, they cannot issue the Euro. The only way we could default is if we choose to do so for self imposed reasons (like the debt ceiling). We are not burdening our grand children with US debt, if anything they are inheriting interest paying assets.
Notes
1. Update 8/14: What happens if China stopped holding on to the dollars and dumped them into the foreign exchange markets, well then the dollar falls due to increased supply. Essentially, 1 USD=6.39 CNY right now, but that ratio falls. US trade deficit falls (after it temporarily increases). Why, because now Chinese goods are more expensive in the US and their demand drops, while US goods are less expensive in China and their demands increases. Our trade deficit becomes ever smaller as China continues to dump dollars. So China can either hold on to the dollars (in the form of treasuries) or dump them in the forex markets killing their export industry. So if anything we have China over a barrel, not the other way around. China used to maintain a peg on the dollar (thus subsidizing its export industry), by holding/buying dollars. If they don't hold/buy enough then the dollars falls.
2.Update 8/14: In reality, the implementation of this no treasuries scenario requires IORs (Interest payments on bank reserves), as economist Scott Fullwiler says. The IOR scenario is functionally identical to treasury bills, and is necessary for the Fed to maintain control of the interest rate, when there is no treasury issuance. And it is no more inflationary than T-bills. In fact since 2008 the Fed has been doing IORs also by adding bank reserves on its liabilities side, to facilitate its balance sheet expansion. Clearly this has not been inflationary, despite many hyperbolic predictions.
Is China lending to us
Essentially no, China's treasury holdings are a function of our trade deficit rather than our budget deficit. When you purchase Chinese goods, do you use dollars or Chinese currency? Dollars obviously. Given that we have a trade deficit with China, Chinese companies end up with excess dollars. Last quarter US exported $36B to China while China exported 650 CNY ($101B) to the US , Chinese companies as a whole have a net addition of 65B US dollars to their bank accounts. They can now use these dollars to buy dollar denominated assets such or US treasuries or US buildings , but then again you need two parties for a sale. Just because somebody wants to buy buildings doesn't mean they are for sale. In actuality what Chinese companies tend do is exchange dollars with the PBOC (Chinese central bank) for their own currency, and thus these dollars end up in China's reserve account (checking account) at the Fed. What will the PBOC do, sit on these dollars that earn no interest? Guess what they do, the vast majority of these dollars go into the purchase of treasuries that earn interest. See economist Randall Wray's post here for more details In Fig 1 from Prof. Wray's post notice how China's share of US treasuries increases as we run ever larger trade deficits with them in the 00's. Click to enlarge.
 |
| Fig 1: Foreign holdings of US treasuries (2000-2010) |
What should be clear now is that China's ownership of US treasuries is a function of the US trade deficit. Here is additional data. Does anyone think it is coincidence that the two countries with we have the largest trade deficits (China & Japan) have the largest foreign holdings of US treasuries at 47%? China can threaten all they want, but as long as they choose to run a trade surplus with us, they are going to end up with dollars. Sure they can buy US stocks instead of US treasuries, but historically they have not shown an appetite for that kind of risk[1].
Why US debt isn't debt
And given that the government is the issuer of currency, why is there even a need to issue debt? Let us say you had your own currency, that you could issue at will and it is accepted everywhere in exchange for goods and services. Will you ever fail to make a payment for lack of funds? What does debt mean in this case? Do you ever need to take on debt to make your payments? For households, state governments, business and even some European governments (in the Euro regime) like Greece, and even Germany, bond issuance is indeed debt, as they are currency users. But for a sovereign currency issuer like the US, Japan, Canada is bond issuance really debt?[2] Then what is it?
Debt issuance is gold standard relic, back from the 19th century, when economists lost the centuries old understanding of the nature of money, and decided to tie the output of the US economy to mines in South Africa. The gold standard is dead and gone for 40 years, but yet policymakers run the country as we are still in one. This is a completely unnecessary straight jacket in a modern fiat system. An issuer of money can never run out said money, solvency is never a restriction, thus the concept of debt is meaningless. The only real restriction on government spending, is inflation. That type of inflation is highly unlikely to happen right now, as we have high unemployment and large under utilization of productive capacity - in other words the metaphorical factories are sitting idle due to lack of demand for their products. Additional money injected (income) into the private sector right now, is far more likely to bring these metaphorical factories online than drive up prices.
Even though the US government doesn't have solvency restrictions, there are a lot of unnecessary political restrictions. They are political in nature, not economic. What we have is the worst of both worlds. A Fed that can issue money at will, and a Treasury which cannot. A Treasury which has accountability and transparency, and a Fed which has none. That is how you end up with a corrupt Fed chairman bailing out banks to the tune of $16T (yes trillion) behind closed doors. These kind of the things shouldn't happen if we are still to remain a democracy. The best of both worlds, would be a Fed and Treasury that have no restrictions in currency issuance with full transparency and accountability.
Why issue treasuries then
But that doesn't mean we should not issue treasuries. They do have other functions. For example the Fed exercises absolute control of the short term interest rate, and is willing to defend it with open market purchases/sales of treasuries. While there is market variability on the longer term treasury yields, that happens only because the Fed allows it. The Fed may choose to purchase a whole lot more of those treasuries in the open market, thus driving down yields. The Fed could purchase all of it, if there is not a single sale in the open market, as we established a currency issuer doesn't really to need to get its own currency from others. But there is no danger of that happening anytime soon, the demand for US treasuries generally exceed supply by 3:1 at treasury auctions. In addition, treasuries represent a risk free savings for the private sector. It is like a welfare program, as we established that the government doesn't really need your funds to operate. As Cullen Roche says the debt clock isn't really a debt clock, it is a national savings clock.
So in conclusion, we don't really have a debt problem. As a currency issuer, we are not going to fail to meet our debt payments, which by the way is in the same currency. We are not Greece, they cannot issue the Euro. The only way we could default is if we choose to do so for self imposed reasons (like the debt ceiling). We are not burdening our grand children with US debt, if anything they are inheriting interest paying assets.
Notes
1. Update 8/14: What happens if China stopped holding on to the dollars and dumped them into the foreign exchange markets, well then the dollar falls due to increased supply. Essentially, 1 USD=6.39 CNY right now, but that ratio falls. US trade deficit falls (after it temporarily increases). Why, because now Chinese goods are more expensive in the US and their demand drops, while US goods are less expensive in China and their demands increases. Our trade deficit becomes ever smaller as China continues to dump dollars. So China can either hold on to the dollars (in the form of treasuries) or dump them in the forex markets killing their export industry. So if anything we have China over a barrel, not the other way around. China used to maintain a peg on the dollar (thus subsidizing its export industry), by holding/buying dollars. If they don't hold/buy enough then the dollars falls.
2.Update 8/14: In reality, the implementation of this no treasuries scenario requires IORs (Interest payments on bank reserves), as economist Scott Fullwiler says. The IOR scenario is functionally identical to treasury bills, and is necessary for the Fed to maintain control of the interest rate, when there is no treasury issuance. And it is no more inflationary than T-bills. In fact since 2008 the Fed has been doing IORs also by adding bank reserves on its liabilities side, to facilitate its balance sheet expansion. Clearly this has not been inflationary, despite many hyperbolic predictions.
Sunday, July 24, 2011
Why the Federal Government should never run a budget surplus
The Federal government should never run a budget surplus, unless there is an offsetting trade surplus. And given that the US runs a large current account deficit (mostly a trade deficit), a budget surplus would indeed be harmful. This easily verifiable fact championed by economists of an MMT stripe [1], seems to elude those in charge of national economic policy. All the recent misguided talk about fiscal austerity among all political stripes, shows how sub-optimal or even damaging this can be. The question is, should we run our economy based on pre-conceived notions or actual facts? The source articles, on which this post is based can be found here (a wonkish post by MMT economist Scott Fullwiler) and here.(by Edward Harrison, who frequently guest posts at the top financial blog Naked Capitalism)
Now let us take a look some data from the US and Eurozone. h/t Scott Fullwiler and Financial Times for these images based on US Government and OECD data. Additional images for the Eurozone and Japan can be found in the Harrison article.
See a pattern?
For those who are not familiar with these terms see here for definitions and examples. Current account is essentially the negative of the capital account. And negative government balance is the government deficit. So we have...
US sectoral balances for the last 60 years have been compiled into an excel spreadsheet by economist Stephanie Kelton, for easy reading. And here is the link to her original article for further reading. It should be clear that in all cases, whether a fiat system or not, when the government runs a budget surplus provided it is not offset by a current account surplus then the private sector is running a deficit, i.e: this is a subtraction to private sector net financial wealth. The inverse also holds true. If the private sector decides to net save (run a surplus), and if the current account is in deficit, then the government sector should run a budget deficit that balances the equation. If it embraces austerity instead, GDP falls, and thus private income falls as a consequence. The sectors will balance regardless, it is a matter of what level of GDP you want them to balance. This is the exact scenario we have been facing in the US and Euro zone since the beginning of the Great Recession.
Why does this hold?
For those who are economics inclined see the Scott Fullwiler article for an explanation. For the general reader I will explicitly spell out what Ed Harrison is stating in his article. I have been sending the source links to people for a year, what I found is many aren't aware that total financial balances always equal zero, even after reading those articles. So forgive the simple example illustrating just that, it maybe necessary for some. This is not an explanation, just an illustration..
Let us say we have 3 people Alice, Jim and Bob. Each starts out with net financial wealth of $500. Note we are only dealing with financial assets balances here not real assets.
Transaction 1: Alice buys eggs from Jim for $10. Obviously now Alice is down $10, while Jim is up $10
Transaction 2: Bob buys bread from Alice for $20.
Transaction 3: Jim buys plumbing service from Bob for $40
After 3 transactions, Alice and Bob now have a positive balance (surplus) of $10 and $20 respectively, while Jim has a negative balance (deficit) of the exact same amount as the total surplus in the system $30. In other words the balance for all three always sums to ZERO, after each transaction. Also note, for any single entity to run a surplus, the sum total of the rest must run a deficit of the same amount.
Now try this same exercise with 50 people, the sum of the balances for all entities after any given period must equal ZERO. Now try this with groups of people, say 3 corporations, it still works. We are just dealing with millions of dollars now. Now let us form three all encompassing groups as Harrison was stating. The government sector, the private sector and the foreign sector. This still holds, and real world data confirms the prediction, see above figures.
If the foreign sector has a surplus, that is the same as a current account deficit from our perspective, so negative foreign sector balance, is positive current account balance.
What is a govt budget deficit?
To hammer the point home even more, let us take look at budget deficits. We obviously have a budget deficit when the federal government spends more than it taxes. So where does this extra deficit money go, does it disappear into thin air? If we assume the current account balance is 0 (exports=imports), then every single one of those government deficit dollars ends up in the private sector, whether it be an additional government workers salary, or the salary of a private employee hired to build railway infrastructure, or a corporate balance sheet from sale of computer equipment. In other words the deficit is income for the private sector. Thus, private sector net wealth as a whole increases by the exact same amount as the federal government deficit. The deficit is essentially creating new money for the private sector.
In the case of the USA, we do have a current account deficit so significant portion of the government deficit dollars, ends up overseas also. Does anyone think it is coincidence that the two countries (China & Japan) with which we have the largest current account deficits (mostly trade deficits) have the largest dollar holdings in the form of treasuries? Nevertheless it should be clear, a federal government deficit increases the net financial wealth of the private sector, provided it is not offset by a current account deficit.
On a quick note, I often hear people say, what about government debt issuance? Isn't that a flow out of the private sector, that balances the deficit inflow? Then I say, are you saying buying $100K of treasuries decreases your financial wealth by $100K? No of course not, it is an financial asset swap. If you move your money from a checking account to a bank CD does your total financial assets change? Buying a treasury is just like buying a CD, it is in you asset column. Your net financial wealth hasn't changed.
What happens if the government runs a surplus. Obviously, it is literally taking more money out of the private sector than it puts back in - a subtraction to the net financial wealth of the private sector. If the budget surplus continues for an extended period, the private sector is literally being depleted. This is unsustainable. In the entire history of the US there were only 5 periods in which we had 5+ years of budget surpluses. As economist Randall Wray points out, each one was followed by a depression. The last extended surplus years were 1920-29, where we reduced the debt by 33%. Guess what followed, the Great Depression. Am I saying the the budget surplus was the cause of the depression? No, but it certainly doesn't help, as the private sector would be net borrowing when the government budget is in surplus.
What are the constraints for deficit spending?
The only real constraint for deficit spending is the total output of the national economy. Spending beyond the economy's production capacity is what results in inflation. Our economy is well below capacity right now. The metaphorical factories are sitting idle. Which is why we have high unemployment. So right now large budget deficits are not a problem. As unemployment decreases, tax revenues increase, unemployment insurance payments decrease, and thus much of the deficit takes care of itself. Note MMT economists are just talking about this one type of inflation. Inflation may still happen due to other issues, such as supply constraints - for example oil supply disruptions or excessive commodity market speculation. Due to the fact the oil is a commodity, other prices may rise. But that type of inflation if it does happen, it would happen regardless of whether we have large deficits or not.
Despite conventional wisdom solvency is not a constraint. Our government is the sovereign issuer of our own flexible exchange rate currency. How can an entity with its own currency ever fail to make a payment in that currency, other than through self-imposed limitations? If you had your own currency that you could issue at will, and your currency is accepted everywhere in exchange for goods and services, will you ever fail to make a payment in the currency. Would you ever need to issue debt, what does debt issuance even mean in this case? But yet that is the dominant conversation these days. Solvency considerations and government debt issuance are gold standard relics. This might seem shocking for those not familiar with MMT, I will address this in a future post. While everyone is aware that we have a fiat system, national economic policy is crafted as though we are still in a gold standard system.
State and local governments, and even European governments (such as Greece, Ireland and even Germany) do indeed have a solvency constraint, as they do not have sovereign control of their currency. On the other hand, governments like Japan, USA, Canada, Australia are true fiat systems, and they do not have a solvency constraint. Japan as of now has a debt level at 200% of GDP and yet their 10yr government bonds are going for just 1.3%. Mainstream economists have been predicting the demise of Japan for the last 20 years, due to high debt levels, high inflation, and high government bond rates, none of which has come to pass. That is because they still base their views on an archaic system. Are MMT economists saying these governments will never default? No, they are saying there will be never a reason for them to default. Lawmakers may still have a collective lobotomy and choose to do so. Japan may choose to default next week, but there is not a single economic reason for them to do that. The US may choose to default if the Republicans don't raise the debt ceiling, but these are self-imposed constraints. It would be about as brilliant as taking a gun and shooting yourself in the leg one day, randomly.
Conclusions
The sectoral financial balances always equal zero, regardless of whether we are in a fiat system or not. If the government runs a budget surplus, without an offsetting current account surplus, then the private sector as a whole is running a deficit, i.e they are net borrowing and hence this is a subtraction to their net financial wealth.
So when the private sector attempts to net save (run a surplus) as in the current recession, the federal government should accommodate that and run a larger budget deficit. This will naturally happen due to reduced tax revenues and increase in the automatic stabilizers (such as unemployment insurance). Any attempts at fiscal austerity while the private sector wishes to save will not end well. Two sectors cannot save at the same time (depending on the foreign sector balance of course) as sectoral financials have to balance. So given that now there is less spending overall (in economics saving is defined as not spending) a further worsening of the recession occurs. If you are familiar with the concept that all spending (GDP) in a country, is all income made in that country, why this happens should be clear. Thus, as spending drops private sector income also drops. Ironically, austerity actually makes the government deficit worse, as government revenues drop due to loss of private income. This is exactly what is going on in many European countries that have chosen austerity. See Ireland, Estonia, Greece. Take a look at Ireland's austerity program begun in 2008, and see how devastating it has been. The GDP finally stopped dropping (for now), but since the article was written unemployment increased another 1% to 14.2%.
The main advantage a true fiat system like ours has over Ireland, is that we have no solvency constraints in running a budget deficit, so austerity makes no sense at all. The only real constraint in deficit spending is inflation. But, our economy is well below capacity, the metaphorical factories are sitting idle, so any additional money injected into the economy is highly unlikely to cause inflation. As unemployment falls, tax revenues rise and unemployment insurance falls, much of the deficit takes care of itself. Approximately 30% of the current deficit is due to the recession alone.
Just any deficit spending probably may not be optimal. If the target is the financial sector(bailouts)it is relatively useless. Even a conventional pump-priming stimulus, (while it does improve things) is unlikely to be that very efficient. MMT economists would say, the best way to reduce the long-term deficit is not worry about the deficit right now, but aim government resources at targeting unemployment directly. The best month the private sector had this year was 200,000 jobs/month. Seems significant, but that is not going to cut it. If we add 200K jobs/month it will take us 11 years to get to 4.5% employment according to this study. If 300K jobs/month then 5 years, if 500K jobs/month then only 2.5 years. Private business are running record profits, but yet they are not hiring, as their hiring decisions are based on consumer demand, which is still very weak, and leaning towards a double dip The government should fill in the employment gap directly, (not through indirect stimulus), if we want a quick recovery. We have a lot of idle construction, why not put that to good use (at least temporarily) repairing the nation's crumbling infrastructure. From 1933-37 this approach was highly successful, when a population adjusted figure of 750,000 jobs/month was the norm, GDP growth averaged 10%/yr and unemployment fell from 23% to 10%. That is, until FDR decided to massively cut the deficit in 1937. Does it is seem that any politician actually learned from this experience? Yeah a government role in job creation conflicts with the ideology of some, but should we run our economy based on unverified ideologies or reality?
Notes:
1. MMT or Modern Monetary Theory is an explanation (not just a theory) of how a modern fiat/credit monetary system really works. And that is what we have in the US and most other major economies except for those European countries under the euro regime.
2. We could have additionally split the private sector into two, whatever is suitable for analyzing financial flow. This maybe even more relevant. In my view, what is really the aim of economic policy but to increase the net financial wealth of the household sector. What is important to know is that the sectoral financial flows always balance, regardless of how many sectors we choose to use. For the household sector to be in surplus the sum of the rest must be in deficit by the same amount. Govt Fin Bal + Household Sector Fin Bal + Business Sector Fin Bal + Foreign Sector Fin Bal = 0
Now let us take a look some data from the US and Eurozone. h/t Scott Fullwiler and Financial Times for these images based on US Government and OECD data. Additional images for the Eurozone and Japan can be found in the Harrison article.
 |
| Fig.1 US Sectoral Financial Balances |
 |
| Fig. 2 Euro Sectoral Financial Balances |
See a pattern?
Private Financial Balance + Government Financial Balance + Capital Account Balance = 0
Private Financial Balance = -Government Financial Balance - Capital Account Balance
For those who are not familiar with these terms see here for definitions and examples. Current account is essentially the negative of the capital account. And negative government balance is the government deficit. So we have...
Private Financial Balance = Government Deficit + Current Account Balance
US sectoral balances for the last 60 years have been compiled into an excel spreadsheet by economist Stephanie Kelton, for easy reading. And here is the link to her original article for further reading. It should be clear that in all cases, whether a fiat system or not, when the government runs a budget surplus provided it is not offset by a current account surplus then the private sector is running a deficit, i.e: this is a subtraction to private sector net financial wealth. The inverse also holds true. If the private sector decides to net save (run a surplus), and if the current account is in deficit, then the government sector should run a budget deficit that balances the equation. If it embraces austerity instead, GDP falls, and thus private income falls as a consequence. The sectors will balance regardless, it is a matter of what level of GDP you want them to balance. This is the exact scenario we have been facing in the US and Euro zone since the beginning of the Great Recession.
Why does this hold?
For those who are economics inclined see the Scott Fullwiler article for an explanation. For the general reader I will explicitly spell out what Ed Harrison is stating in his article. I have been sending the source links to people for a year, what I found is many aren't aware that total financial balances always equal zero, even after reading those articles. So forgive the simple example illustrating just that, it maybe necessary for some. This is not an explanation, just an illustration..
Let us say we have 3 people Alice, Jim and Bob. Each starts out with net financial wealth of $500. Note we are only dealing with financial assets balances here not real assets.
Transaction 1: Alice buys eggs from Jim for $10. Obviously now Alice is down $10, while Jim is up $10
Transaction 2: Bob buys bread from Alice for $20.
Transaction 3: Jim buys plumbing service from Bob for $40
After 3 transactions, Alice and Bob now have a positive balance (surplus) of $10 and $20 respectively, while Jim has a negative balance (deficit) of the exact same amount as the total surplus in the system $30. In other words the balance for all three always sums to ZERO, after each transaction. Also note, for any single entity to run a surplus, the sum total of the rest must run a deficit of the same amount.
Alice Bal + Bob Bal + Jim Bal = 0
 |
| Table 1: Financial Balances |
Now try this same exercise with 50 people, the sum of the balances for all entities after any given period must equal ZERO. Now try this with groups of people, say 3 corporations, it still works. We are just dealing with millions of dollars now. Now let us form three all encompassing groups as Harrison was stating. The government sector, the private sector and the foreign sector. This still holds, and real world data confirms the prediction, see above figures.
Government Financial Bal + Private Sector Financial Bal + Foreign Sector Financial Bal = 0
Private Financial Bal = -Government Financial Bal - Foreign Financial Bal
If the foreign sector has a surplus, that is the same as a current account deficit from our perspective, so negative foreign sector balance, is positive current account balance.
Private Financial Bal = Govt Deficit + Current Account Bal[2]
What is a govt budget deficit?
To hammer the point home even more, let us take look at budget deficits. We obviously have a budget deficit when the federal government spends more than it taxes. So where does this extra deficit money go, does it disappear into thin air? If we assume the current account balance is 0 (exports=imports), then every single one of those government deficit dollars ends up in the private sector, whether it be an additional government workers salary, or the salary of a private employee hired to build railway infrastructure, or a corporate balance sheet from sale of computer equipment. In other words the deficit is income for the private sector. Thus, private sector net wealth as a whole increases by the exact same amount as the federal government deficit. The deficit is essentially creating new money for the private sector.
In the case of the USA, we do have a current account deficit so significant portion of the government deficit dollars, ends up overseas also. Does anyone think it is coincidence that the two countries (China & Japan) with which we have the largest current account deficits (mostly trade deficits) have the largest dollar holdings in the form of treasuries? Nevertheless it should be clear, a federal government deficit increases the net financial wealth of the private sector, provided it is not offset by a current account deficit.
On a quick note, I often hear people say, what about government debt issuance? Isn't that a flow out of the private sector, that balances the deficit inflow? Then I say, are you saying buying $100K of treasuries decreases your financial wealth by $100K? No of course not, it is an financial asset swap. If you move your money from a checking account to a bank CD does your total financial assets change? Buying a treasury is just like buying a CD, it is in you asset column. Your net financial wealth hasn't changed.
What happens if the government runs a surplus. Obviously, it is literally taking more money out of the private sector than it puts back in - a subtraction to the net financial wealth of the private sector. If the budget surplus continues for an extended period, the private sector is literally being depleted. This is unsustainable. In the entire history of the US there were only 5 periods in which we had 5+ years of budget surpluses. As economist Randall Wray points out, each one was followed by a depression. The last extended surplus years were 1920-29, where we reduced the debt by 33%. Guess what followed, the Great Depression. Am I saying the the budget surplus was the cause of the depression? No, but it certainly doesn't help, as the private sector would be net borrowing when the government budget is in surplus.
What are the constraints for deficit spending?
The only real constraint for deficit spending is the total output of the national economy. Spending beyond the economy's production capacity is what results in inflation. Our economy is well below capacity right now. The metaphorical factories are sitting idle. Which is why we have high unemployment. So right now large budget deficits are not a problem. As unemployment decreases, tax revenues increase, unemployment insurance payments decrease, and thus much of the deficit takes care of itself. Note MMT economists are just talking about this one type of inflation. Inflation may still happen due to other issues, such as supply constraints - for example oil supply disruptions or excessive commodity market speculation. Due to the fact the oil is a commodity, other prices may rise. But that type of inflation if it does happen, it would happen regardless of whether we have large deficits or not.
Despite conventional wisdom solvency is not a constraint. Our government is the sovereign issuer of our own flexible exchange rate currency. How can an entity with its own currency ever fail to make a payment in that currency, other than through self-imposed limitations? If you had your own currency that you could issue at will, and your currency is accepted everywhere in exchange for goods and services, will you ever fail to make a payment in the currency. Would you ever need to issue debt, what does debt issuance even mean in this case? But yet that is the dominant conversation these days. Solvency considerations and government debt issuance are gold standard relics. This might seem shocking for those not familiar with MMT, I will address this in a future post. While everyone is aware that we have a fiat system, national economic policy is crafted as though we are still in a gold standard system.
State and local governments, and even European governments (such as Greece, Ireland and even Germany) do indeed have a solvency constraint, as they do not have sovereign control of their currency. On the other hand, governments like Japan, USA, Canada, Australia are true fiat systems, and they do not have a solvency constraint. Japan as of now has a debt level at 200% of GDP and yet their 10yr government bonds are going for just 1.3%. Mainstream economists have been predicting the demise of Japan for the last 20 years, due to high debt levels, high inflation, and high government bond rates, none of which has come to pass. That is because they still base their views on an archaic system. Are MMT economists saying these governments will never default? No, they are saying there will be never a reason for them to default. Lawmakers may still have a collective lobotomy and choose to do so. Japan may choose to default next week, but there is not a single economic reason for them to do that. The US may choose to default if the Republicans don't raise the debt ceiling, but these are self-imposed constraints. It would be about as brilliant as taking a gun and shooting yourself in the leg one day, randomly.
Conclusions
The sectoral financial balances always equal zero, regardless of whether we are in a fiat system or not. If the government runs a budget surplus, without an offsetting current account surplus, then the private sector as a whole is running a deficit, i.e they are net borrowing and hence this is a subtraction to their net financial wealth.
So when the private sector attempts to net save (run a surplus) as in the current recession, the federal government should accommodate that and run a larger budget deficit. This will naturally happen due to reduced tax revenues and increase in the automatic stabilizers (such as unemployment insurance). Any attempts at fiscal austerity while the private sector wishes to save will not end well. Two sectors cannot save at the same time (depending on the foreign sector balance of course) as sectoral financials have to balance. So given that now there is less spending overall (in economics saving is defined as not spending) a further worsening of the recession occurs. If you are familiar with the concept that all spending (GDP) in a country, is all income made in that country, why this happens should be clear. Thus, as spending drops private sector income also drops. Ironically, austerity actually makes the government deficit worse, as government revenues drop due to loss of private income. This is exactly what is going on in many European countries that have chosen austerity. See Ireland, Estonia, Greece. Take a look at Ireland's austerity program begun in 2008, and see how devastating it has been. The GDP finally stopped dropping (for now), but since the article was written unemployment increased another 1% to 14.2%.
The main advantage a true fiat system like ours has over Ireland, is that we have no solvency constraints in running a budget deficit, so austerity makes no sense at all. The only real constraint in deficit spending is inflation. But, our economy is well below capacity, the metaphorical factories are sitting idle, so any additional money injected into the economy is highly unlikely to cause inflation. As unemployment falls, tax revenues rise and unemployment insurance falls, much of the deficit takes care of itself. Approximately 30% of the current deficit is due to the recession alone.
Just any deficit spending probably may not be optimal. If the target is the financial sector(bailouts)it is relatively useless. Even a conventional pump-priming stimulus, (while it does improve things) is unlikely to be that very efficient. MMT economists would say, the best way to reduce the long-term deficit is not worry about the deficit right now, but aim government resources at targeting unemployment directly. The best month the private sector had this year was 200,000 jobs/month. Seems significant, but that is not going to cut it. If we add 200K jobs/month it will take us 11 years to get to 4.5% employment according to this study. If 300K jobs/month then 5 years, if 500K jobs/month then only 2.5 years. Private business are running record profits, but yet they are not hiring, as their hiring decisions are based on consumer demand, which is still very weak, and leaning towards a double dip The government should fill in the employment gap directly, (not through indirect stimulus), if we want a quick recovery. We have a lot of idle construction, why not put that to good use (at least temporarily) repairing the nation's crumbling infrastructure. From 1933-37 this approach was highly successful, when a population adjusted figure of 750,000 jobs/month was the norm, GDP growth averaged 10%/yr and unemployment fell from 23% to 10%. That is, until FDR decided to massively cut the deficit in 1937. Does it is seem that any politician actually learned from this experience? Yeah a government role in job creation conflicts with the ideology of some, but should we run our economy based on unverified ideologies or reality?
Notes:
1. MMT or Modern Monetary Theory is an explanation (not just a theory) of how a modern fiat/credit monetary system really works. And that is what we have in the US and most other major economies except for those European countries under the euro regime.
2. We could have additionally split the private sector into two, whatever is suitable for analyzing financial flow. This maybe even more relevant. In my view, what is really the aim of economic policy but to increase the net financial wealth of the household sector. What is important to know is that the sectoral financial flows always balance, regardless of how many sectors we choose to use. For the household sector to be in surplus the sum of the rest must be in deficit by the same amount. Govt Fin Bal + Household Sector Fin Bal + Business Sector Fin Bal + Foreign Sector Fin Bal = 0
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