Regular readers will know that I have spent quite a lot of time reading the…
Size of deficit 101
I rode my bike 80 kms early this morning (usual Sunday) in the beautiful Autumn weather that Newcastle (NSW) enjoys this time of year. The Pacific Ocean looks superb (although there is nothing surfable in sight – maybe tomorrow morning). The sun was out and we were heading for 26-27 degrees. Then it had to happen. When I returned home I opened this morning’s newspaper and came across an authoritative headline: US faces huge deficit blow-out, with the sub-line “Program cuts, tax hikes likely.” The journalist (added to my bogan list) probably got 0 out of 5 on last night’s quiz. Well the truth is that almost everything the journalist wrote is wrong if he is talking about the real world. Anyway, I thought so. Its that time again. Time to debrief.
The hard copy article was ascribed to one Andrew Taylor in Washington but the Internet version, which is longer, is attributed to Associated Press. Whatever, the logic is so bad that it is likely to damage the life experiences of those who read it.
It starts by asserting that the current US budget (estimates derived from the Congressional Budget Office (CBO)):
… will generate unsustainably large deficits averaging almost $US1 trillion ($1.5 trillion) a year over the next decade …
Apparently this is $US2.3 trillion higher than predicted previously. Note the journalist uses the word worse not higher which tells you almost everything about his ideological persuasion. The budget balance cannot be reasonably called better or worse. That is what you pledge when you get married. The budget deficit as an ex post accounting statement may be higher or lower in dollars.
Then the article went on, getting more desperate as we go:
Worst of all, CBO says the deficit under Obama’s policies would never go below 4% of the size of the economy, figures that economists agree are unsustainable. By the end of the decade, the deficit would exceed 5% of gross domestic product, a dangerously high level.
The latest figures, even worse than expected by top Democrats, throw a major monkey wrench into efforts to enact Obama’s budget, which promises universal health care for all and higher spending for domestic programs like education and research into renewable energy.
The dismal deficit figures, if they prove to be accurate, inevitably raise the prospect that Obama and his allies controlling Congress would have to consider raising taxes after the recession ends or paring back his agenda.
Which economists agree that a 5 per cent deficit is “unsustainable”? What does unsustainable mean? We know this cannot possibly be referring to the ability of the US Federal government to pay its bills each month – the US government is sovereign in the USD. It can buy whatever is for sale and pay any liability that is against it in USD. So what gives? As we see in the second and third paragraph, the claim is that taxes will have to be raised. More about which later.
Why is 5 per cent a “dangerously high level”? In relation to what? Not once did the article mention the sharply deteriorating labour market situation in the US with unemployment rates sky-rocketed as firms lay off workers because their is no demand for the goods and services that they make or provide. Nor did the journalist provide any estimates of the volume of saving that the US private sector might desire at present, as everyone pulls their belts in and hopes to build a buffer against job loss.
Why not? These are crucial macroeconomic details that you have to consider when assessing government policy.
Here is a summary of the current labour report from the US Bureau of Labor Statistics, the government body that administers their labour force survey.
THE EMPLOYMENT SITUATION: FEBRUARY 2009
Nonfarm payroll employment continued to fall sharply in February (-651,000), and the unemployment rate rose from 7.6 to 8.1 percent … Payroll employment has declined by 2.6 million in the past 4 months. In February, job losses were large and widespread across nearly all major industry sectors …
The number of unemployed persons increased by 851,000 to 12.5 million in February, and the unemployment rate rose to 8.1 percent. Over the past 12 months, the number of unemployed persons has increased by about 5.0 million, and the unemployment rate has risen by 3.3 percentage points …
The unemployment rate continued to trend upward in February for adult men (8.1 percent), adult women (6.7 percent), whites (7.3 percent), blacks (13.4 percent), and Hispanics (10.9 percent). The jobless rate for teenagers was little changed at 21.6 percent. The unemployment rate for Asians was 6.9 percent in February, not seasonally adjusted …
The number of long-term unemployed (those jobless for 27 weeks or more) increased by 270,000 to 2.9 million in February. Over the past 12 months, the number of long-term unemployed was up by 1.6 million …
You get the picture very quickly, that if the US Budget Deficit is around 5 per cent of GDP then it probably is not yet high enough to do what it has to do – and that is plug the spending gap left by the meltdown in the US economy.
In February, I read Report which carried the headline “GM sales fall 53% in February, Ford off 48%, Chrysler 44%, Toyota 40%, Honda 38%, Nissan 37%, Hyundai sales buck trend.” Read: a private spending meltdown is destroying jobs in the US.
Question: which sector is left to fill the spending gap? Answer: the US Federal deficit!
To understand the sort of logic that the article is using, and, as my earlier blogs have already mentioned, mainstream economics tries to draw an analogy between the household and the sovereign government such that any excess in government spending over taxation receipts have to be “financed” in two ways: (a) by borrowing from the public; and (b) by printing money.
Of-course, the analogy is flawed at its most elemental level. The household must work out the financing before it can spend. The household cannot spend first. The government can spend first and ultimately does not have to worry about financing such expenditure.
Anyway, the mainstream framework for analysing these choices is called the government budget constraint (GBC). The GBC says that the budget deficit in year t is equal to the change in government debt over year t plus the change in high powered money over year t. So in mathematical terms it is written as:
which you can read in English as saying that Budget deficit = Government spending + Government interest payments – Tax receipts.
However, this is merely an accounting statement. It has to be true if things have been added and subtracted properly in accounting for the dealings between the government and non-government sectors.
In mainstream economics, money creation is erroneously depicted as the government asking the central bank to buy treasury bonds which the central bank in return then prints money. The government then spends this money. This is called debt monetisation and we have shown in the Deficits 101 series how this conception is incorrect. Anyway, the mainstream claims that if the government is willing to increase the money growth rate it can finance a growing deficit but also inflation because there will be too much money chasing too few goods! But an economy constrained by deficient demand (defined as demand below the full employment level) responds to a nominal impulse by expanding real output not prices.
But because they believe that inflation is inevitable if “printing money” occurs, mainstream economists recommend that governments use debt issuance to “finance” their deficits. But then they scream that this will merely require higher future taxes. Why should taxes have to be increased?
Well the textbooks are full of elaborate models of debt pay-back, debt stabilisation etc which all “prove” (not!) that the legacy of past deficits is higher debt and to stabilise the debt, the government must eliminate the deficit which means it must then run a primary surplus equal to interest payments on the existing debt. Nothing is included about the swings and roundabouts provided by the automatic stabilisers as the results of the deficits stimulate private activity and welfare spending drops and tax revenue rises automatically in line with the increased economic growth. Most orthodox models are based on the assumption of full employment anyway, which makes them nonsensical depictions of the real world.
More sophisticated mainstream analyses focus on the ratio of debt to GDP rather than the level of debt per se. They come up with the following equation:
So the change in the debt ratio is the sum of two terms on the right-hand side: (a) the difference between the real interest rate (r) and the GDP growth rate (g) times the initial debt ratio; and (b) the ratio of the primary deficit (G-T) to GDP.
A growing economy can absorb more debt and keep the debt ratio constant. For example, if the primary deficit is zero, debt increases at a rate r but the debt ratio increases at r – g.
The orthodox economists then use this analysis to argue that permanent deficits are bad because the financial markets will “penalise” a government living on debt. If the debt ratio is too high markets “lose faith” in the government. So as an example (deliberately designed to make the numbers easy), assume a debt ratio of 100 per cent and a current real interest rate (r) of 3 per cent and GDP is growing (g) at 2 per cent. This would require a primary surplus of 1 per cent of GDP to stabilise the debt ratio (check it for yourself).
Now what if the financial markets want a risk premium on domestic bonds? Also assume the central bank is worried about inflation and pushes nominal interest rates up so that the real rate (r) rises to 6 per cent. Also assume the high interest rates drive g to 0 per cent (GDP growth falls to zero). So now the primary surplus has to rise to 6 per cent of GDP to stabilise debt. The sharp fiscal contraction leads to recession. The government becomes unpopular and uncertainty drives further rate rises. It becomes even harder to stabilise debt as r rises and g falls.
The mainstream conclusion is that governments are thus constrained by market forces which determine the quantity of debt the government can issue as well as the price (interest rate) of the debt. Taxation is also considered to provide disincentives to work and take risks. Therefore, governments have to balance budgets once they have run surpluses for long enough to pay off past debt accumulation.
You will immediately pick up on the flaws in this logic. First, the government doesn’t have to issue debt if it is happy to keep interest rates flat-lining at about zero. Second, the government can always pay its interest bill if it is in its own currency. Third, what happens if the private sector will not buy the bonds? Not a lot. The spending would still be made and have a positive effect (assuming there is excess capacity in the economy) and the bank reserves would sit there not earning market rates. Consumers might then choose to spend the excess bank reserves and then the automatic stabilisers would reduce the deficit. Not a lot wrong with any of that. Fourth, deficits stimulate growth and the central bank sets the short-term interest rate. Both work against the mainstream logic.
But lets get back to the article now that we have had a little rest from it. Apparently, even the White House budget chief, one Peter Orszag said that if the CBO forecasts are accurate, then the US would have “unsustainable deficits. Deficits in the, let’s say, 5% of GDP range would lead to rising debt-to-GDP ratios that would ultimately not be sustainable …”
The Chief economist at Moody’s (one Mark Zandi) was quoted as saying:
Deficits so big put upward pressure on interest rates as the government offers more attractive interest rates to attract borrowers.
I think deficits of 5% (of GDP) is unsupportable … It will lead to higher interest rates to the point where it will force policymakers to make changes.
Eh, Mark, spin us a story about Japan while you are at it. Huge yen budget deficits, zero interest rates, negative inflation … for more 14 odd years!
The facts are that budget deficits put downward pressure on interest rates. It is up to the central bank to decide if they want rates to fall and if they do not they will sell government paper (debt) to soak up the excess funds that are putting downward pressure on rates in the interbank market as commercial banks scurry to get market returns on the excess reserves. These statements are just plain wrong.
The next part of the article then became predictable. When you have exhausted all the other scare-tactics it is time to turn to the “beat up our children” argument. A top Republican on the Budget Committee (one Senator Judd Gregg) chimed in with the ludicrous:
Under the president’s plan, our debt will increase to shocking levels that are simply unsustainable and will devastate future economic opportunities for our children and grandchildren
Whoa, I forget … and our children’s children!
Readers are referred to my blog on the myths of the Intergenerational Debate to realise how nonsensical the senator’s statement is.
The fact is that none of Obama’s programs are under threat by the extra spending that is needed to stabilise the very poorly performing US economy. They may be under threat politically but that is another question. He can still conduct comprehensive health care reform and reduce the US dependency on foreign oil and start building a renewable energy sector. He always has the fiscal capacity to do that. Whether now is the time is another matter. It has nothing to do with the current size of the deficit.
He should also immediately announce an unconditional offer of a public sector job at the minimum wage (after increasing it to reasonable living standards) to anyone that wants one. This would provide hundreds of thousands of jobs to low skill workers (and anyone else who wanted one) to engage the workers in countless community development and environmental care service projects. If they had already done this years ago, the sub-prime crisis would have been much less of an impact than it is now. People would have had stable incomes and been able to pay their mortgages. But better late than never.
Obama can still afford all of this and more because: (a) the US government has a monopoly in the issue of USD; and (b) there is presumably massive quantities of free resources available for purchase and productive use that are currently lying idle due to the recession.
When considering the limits of government net spending, these two points are the only issues that matter. The government can buy anything available for sale. It should do that if the private sector is currently not buying enough to generate full employment. All these other smokescreens are examples of the sort of logic that led us to this crisis in the first place. Orthodox economics has very little to offer at the best of times. In times like this, the mainstream have nothing to offer that is sensible and should just go away.
And finally, the article I started talking about did not mention unemployment once. It takes some hide to write a story like that I reckon. My bogan journalist register has just acquired another entry.
This Post Has 5 Comments
Bill, I often hear it commented around the blogs that as soon as solid growth resumes, the increased money in circulation from all the stimulus packages will result in inflation, and that the greater the size of the defecit used to “finance” these, the worse it will end up being.
Now if only sovereign government can create or destroy monetary wealth, where has all the money that dissapeared during the stock market crash gone to? Obviously it still exists, salted away in various places. What I’m asking is, if the same net amount of monetary value that existed before the crash is still in existence, just not in circulation, is it possible that when growth resumes and confidence returns, this money could all come flooding back into circulation, and in combination with the stimulus packages pumped in by governments around the world, the new increased sum of money actually become inflationary? Notwithstanding the tendancy for output to increase first?
I would stop reading those blogs if I was you! They are pushing out convoluted nonsense.
First, net spending by the government is a flow not a stock. So there is a flow of spending going on each day and flows out of the system (via taxation and/or bond sales). Flows in and flows out.
Second, the net financial assets created are a stock which you are calling “increased money”. The accumulation of which represent the cumulative budget deficits (flows feed stocks).
Third, the net spending flow associated with deficits goes to purchase goods and services and/or financial assets (bank deposits etc) depending on who gets the initial bank deposits. While there is still unemployment above some low figure (say 2 per cent) then we can conclude that private spending is still insufficient to purchase a flow of output consistent with a fully employed labour force. In these situations, the deficit (as a flow) has to be increasing until every day the flow of funds fills the gap left by private saving (also a flow).
Fourth, the sovereign government is the only entity that can create/destroy net financial assets in the currency of issue. Any financial asset (say credit) that is created in the non-government sector is always offset $-for-$ by a matching liability. So the bank might extend you a loan by crediting an account in your name but at the same time it debits and asset (called Loan to Lefty) – it has a liability to you (the deposit which you can draw down) but an asset against you (the promise by you to pay back). So no net financial asset is created. This will be the same right across the range of transactions between non-government entities. Only transactions between the government and non-government sectors create/destroy net financial assets.
Fifth, while the stock market was booming, the federal government was actually destroying net financial assets because it was running a surplus (the two events more or less coincided). The stock market boom was fuelled by non-government credit laxity and so nothing net was created. Some people bought shares (an asset) but borrowed to pay for them (an equal liability). So there really isn’t “all this money salted away”. When the share market started to unwind and nominal values crashed the new owner of the cheaper share gets an asset worth X, the old owner writes down an asset (the loss) and the creditor retains the debt. They all net to zero. Nothing is going to suddenly come “flooding back” because there isn’t anything there!
Sixth, the deficit (as a flow) is propping up the economy by filling the spending gap. Once growth resumes, then the automatic stabilisers I have talked about will reduce the deficit without the government doing anything. So as the private spending grows (for constant productive capacity), the need for the flow of net government spending is reduced. It would only be inflationary if the deficit expanded at the same time as private spending expanded and the sum of the two flows was greater than the flow of production into the economy that has to be purchased. That is unlikely to happen.
Tell those inflation scare mongers to take a nice walk in the sun and relax a bit.
hope that helps
Dear Mr Mitchell,
Regarding the fact that the non-governmental sector cannot create/destroy NET assets, I’m just wondering what happens when, for example, a loan is issued for $100 dollars to Mr. X by Bank Y. Mr. X then spends the money and begins making payments on the loan. Subsequently, Mr. X goes bankrupt prior to the paying off of the loan from Bank Y, thereby leaving $50 total remaining on the loan (let’s pretend there is no interest). Now if the bank writes down the loss there is an imbalance, only $50 has been destroyed, leaving $50 in net assets floating around. What happens to this $50, it seems like there has been a net asset created due to the default of the borrower. How is this issue resolved, or is it not even an issue and I’m just misunderstanding something.
Default on the loan does not alter net financial assets within the private sector. The bank loses a net financial asset (writes off the loan asset, liabilities unchanged), and the defaulter gains a net financial asset (loses the loan liability, assets unchanged) of equal value.
Creation of a bank loan leaves NFA unchanged for both bank and borrower.
Repayment of loan principal leaves NFA unchanged for both bank and borrower.
Repayment of interest increases bank NFA and decreases non-bank NFA equally.
Default on a loan reduces bank NFA and increases non-bank NFA equally.
Hope that helps.
Paradigm, that’s a good summary, the best you can get with one liners.
I would love to see a step by step operational description of the balance sheets changes in the four cases.
So far I’ve only seen the first one. Does anyone know where to find the other 3?