Wednesday, June 22, 2011

Why We Need Deficits

For the past two weeks, have been studying MMT or Modern Monetary theory. New Economic Perspectives and Billy Blog are good places to go to get both flavor and details of MMT. If these folks are right, and they make mighty persuasive arguments, we don't have a deficit problem. What's more, the idea that we have a looming sovereign debt level crisis, that our public debt to GDP is moving into an unsustainable range, is just plain wrong. I will be returning to this a lot in the future, since it turns the current political conversation on it's head. But let me start out with just a few headlines:

     1.  The US, and other sovereign countries with their own currencies, cannot go broke. The comparison with an individual household that can go broke is simply wrong. Any sovereign country, with a "fiat currency", can simply issue new currency or debt to pay outstanding obligations.

     2.  We hear talk of sovereign debt default. Turns out no sovereign nation with their own currency not pegged to a fixed rate or a currency board has ever defaulted. Russia, Argentina, et al. were pegged to rates when they defaulted.

     3.  We are told with absolute certainty that serious inflation is just around the corner, that the budget deficits and the increasing debt levels will without any question lead to out of control inflation. This is the famous bond vigilante conversation: people/institutions/markets will lose confidence in US economic policy, will massively sell Treasuries, prices of the bonds will tank, interest rates will spike, and inflation will take off. It simply has not happened. Ten year Treasuries remain near 3%, almost historical lows.

     4.  We are told that formal economic studies show conclusively that public debt to GDP levels cannot go above 60% or major inflation and economic breakdown will occur. Meanwhile, Japan's debt level just passed 200%, while interest rates remain near zero with little inflation in sight. The economy has struggled along with low growth for 20 years, because zombie banks and businesses have been nursed along instead of shut down or restructured. But no inflation. No default. No problem raising funds in the bond markets, even though Japan was downgraded by Standard & Poor.

Where does this anti-deficit, inflation fearing, debt/insolvency concern come from? Republicans have held these views for a long time, perhaps forever, but certainly from before the New Deal. But through the New Deal and through the Johnson years and Medicare/Medicaid of the 60s', Democrats have been strong supporters of fiscal policy and deficits to support public policy. Now most join Republicans in their anti-stimulus, ant-deficit, budget-cutting policy proposals. Why? I am honestly not sure, but austerity mania is clearly a trans-Atlantic phenomenon, dominating Britain and the troubled peripheral countries of Europe and the ECB. Almost everyone seems to buy into the idea that the way to grow is to cut spending, shrink the deficit, balance the budget, reduce debt. Contractionary expansion. And MMT says this is just plain wrong.

MMT tells us that government sector budget deficits are necessary to support private sector savings and external sector trade imbalance. This is not opinion. This is accounting identity. In my next blog, I will show the quite simple math, but for now, the conclusion: Fund flows in the three sectors must net to zero.

So, Government ( G-T, Spending less Taxes), Private (S-I, Private Savings less Private Investment), External (X-M, Exports less Imports) - the net of these three sector balances must equal zero. So Government Deficits must be present if the External Balance is negative and the Private sector is net saving. Said differently, the Sources and Uses of funds in the three sectors must net to zero. Deficits are a Source. Net Private Saving and a negative Trade Balance are both Uses. So if there is Private Saving and a negative Trade Balance, there will be Government Deficits. This is not opinion. This is simple math.

So how did Clinton achieve a budget surplus and good GDP growth? Private credit expansion. How have we had such generally positive economic growth in the last thirty years  not running up large deficits until the end of the period? To a very large extent, private credit expansion. Looking at the Private Debt accumulation in the last thirty years is a sobering experience. Until very recently, we have not needed the Government to fund Private Saving and our Trade Imbalance. The consumer and private business have been doing it through private credit expansion, i.e., dis-saving.

Starting in 2007, and surging ahead with the September, 2008 crisis, both the consumer and business are deleveraging, paying off debts, repairing the balance sheet. That is the main reason for the deficits. And that is why we can call this the Balance Sheet Recession.

We need deficits, or else we will starve our economy. Austerity is exactly the wrong way to go. How long this recession lasts will depend on how long it takes the private consumer and business to repair their balance sheets. And unless we want to follow the Japanese, we should not continue to support our zombie banks. And if they can be put through resolution, we can address the underwater mortgage disaster through serious mortgage modifications, and help significantly to clean up private balance sheets.

In my next post, will look for some charts to demonstrate the above.

1 comment:

  1. I love it. Thanks Jim for making everything so clear. I look forward to your next installment.