Our Shared Economic Storyline is Wrong

Here's what I believe both political parties agree to, our shared economic storyline:

The US is in the middle of a debt crisis caused by large government deficits (2008-2011). It is imperative that these deficits be eliminated, although there is disagreement on timing. Democrats say we should fund deficits a bit longer to reduce unemployment, then move to balance the budget. Republicans do not think government spending can create jobs, so they want a balanced budget immediately.

But balance the budget we must, whether we do it sooner or later. If we don't, there are a continuum of negative outcomes that both parties agree on - higher inflation, higher interest rates, bond market rejection of US bonds, leading to either hyperinflation or sovereign default, all the while watching a debasement of our currency.

In other words, we are broke. The US credit card is maxed out. And just like a private household, we have to stop borrowing, lower our debt levels, and bring spending into line with revenues. Any further increase in debt will either lead to outright default or runaway inflation. In any case, if we really cared about our kids and grandkids, we wouldn't be burdening them with all this debt.

This is the shared narrative. Democrats want to spend some more on jobs, then combine tax increases with spending cuts to balance the budget. Republicans do not want to spend more money on stimulus (it didn't/doesn't work) and they oppose any tax hikes. They want to achieve balance through cuts alone. Republicans want to enshrine the commitment to budget balance through a constitutional amendment. Democrats oppose this - not because they don't want balanced budgets, but because they feel such a requirement would unnecessarily tie government's hands - which, of course, is exactly what Republicans want.

No one in the political arena - no Republican or Democratic party leaders have questioned the underlying narrative. Deficits are a problem. We have to fix the problem before we go broke. Households go into bankruptcy. The US would suffer sovereign default. And what happens then? No one knows; but it won't be good.

The problem is that this storyline is wrong. I will certainly not convince anyone in a single blog, or even in a series of posts. What I hope to do is to raise a small element of doubt in your mind. I will bring forward evidence in future posts from a variety of modern economists, most of whom are part of what is called Modern Monetary Theory. I will give links and references. I hope you will go and look. What you may find, as I have, is that there is a very solid, credible school of economic thought that presents a picture completely different from our shared storyline. For example:




          Storyline Myth #1 - We are in a debt crisis and if we don't address it, we will go broke (sovereign default).
          MMT Response - The US issues its own sovereign currency that is not tied to gold (since 1971) or any other currency. We cannot go broke, or be declared insolvent, as long as our debts are in our own currency. When a debt comes due, the Fed will pay it (in currency or bonds) with a few computer keystrokes. There is no bill that could come due that could not be paid in this manner. Let's say the Chinese decided to cash in their dollar holdings. The Fed would be the logical buyer, including a three way trade with, say, the Bank of Japan (if they wanted to move into yen), or the ECB, if China wanted to diversify into Euros. In doing so, the Fed would create a ton of new base money (M0), but contrary to monetarist tenets, this need not be highly inflationary, nor need it destroy the dollar.

          Storyline Myth #2 - Deficits are bad. They aggravate our debt problem, increase the financial burden on our kids and grandkids, and, if unchecked, will lead to default.
          MMT Response - Deficits mean Government is putting more spending into the economy than it is taking out in the way of taxes - thus deficits add to demand, contributing to GDP and generating employment. There are two other sources of demand in the GDP equation: private net spending (business investment less private savings) and net exports (exports less imports). Government deficits add to demand; a surplus takes away - i.e., if taxes exceed spending, more is being taken out than is being put back in. Net private spending is, in a healthy economy, slightly negative - private households are saving more than business is investing, which leaves this sector as a user (not a source) of demand funds. As for Net Exports, or the Trade Balance, the US almost always runs a trade deficit (exports are less than imports). This, like Net Private Saving, is a use of funds, not a source. By simple accounting identity: Government deficits are necessary if the private sector is net saving and we run trade deficit. Unless we (highly unlikely) began running trade surpluses, we need deficits. Otherwise private households must dis-save, i.e., borrow more. This is how we got the Clinton surpluses: an increase in private indebtedness that blew out and eventually blew up in the Bush years, leading to the 2008 credit crisis. The US needs deficits, now, and most likely forever. As far as building an unsustainable debt burden for future generations, the surprising and unknown math fact is that if real GDP growth exceeds real interest on the debt, over time the debt/GDP ratio stabilizes, which means annual debt service stabilizes, and remains manageable.

          Storyline Myth #3 - Deficits raise the money supply and cause inflation. Enough inflation and bond yields will skyrocket; the government won't be able to fund its debt; and default could ensue.
          MMT Response - GDP is the sum of four spending streams: private consumption, business investment, government spending and net exports. Each of these spending streams represents output flows in the economy - all of which call forth production inputs to deliver the desired goods and services. If the economy is operating near its capacity, any one of these streams, and certainly all of them together can put pressure on the economy's operating system, and if scarcities show up, prices will rise. Deficits (government spending less tax receipts) does increase the money supply by injecting new financial assets into the economy (printing money - when the bills are being paid, the Fed credits various banks (who then credit the various suppliers who did the work being paid for), and in doing so creates new money with a few computer keystrokes. Milton Friedman and his Monetarist School told us raising the money supply created inflation. New research has shown the correlation between money supply changes and inflation to be weak at best. So yes, deficits, just like other streams of spending can stimulate inflation, if the economy is operating at or near capacity, not because there is an increase in the money base (M0). If capacity is tight, we must watch out for inflation. If (like now) there is huge, unutilized capacity in the economy, there is no inflation risk, even if M0 rises with the deficits.
          As for serious upward movement in interest rates, excess reserves (new money base or M0) created by deficit spending, actually puts downward pressure on rates, as banks compete with each other to get the best overnight return on their reserves. We see this now, as banks are sitting on a pile of excess reserves (deficits, Quantitative Easing), over $1.5 trillion.
          In future posts, will provide evidence for the above claim that neither deficits nor money supply increases cause inflation. As a simple case study, we will look at Japan: almost continuous deficits since 1991, no inflation, rock bottom interest rates, debt to GDP ratio of 200% (three times our 65%) with no problems finding buyers for their bonds, and a rock solid currency (the Bank of Japan has just become an aggressive seller of yen, to drive down yen prices, so exports won't be hurt).

Deficits are necessary. Like any spending stream, if the economy is near capacity, there is risk of inflation; otherwise, no. Deficits are not inflationary; inflation is not mostly a monetary phenomenon, as Friedman claimed. It is a function of the real economy and its level of capacity utilization. Rising commodity prices are one of the inputs, but not the only one. Plant utilization, labor pool, unemployment levels, and others also play a role in determining whether prices will start moving up, or not. The US cannot become insolvent, or be forced to default - as long as our obligations are in dollars.

So if deficits are OK (if we keep an eye out for capacity bottlenecks), and they don't lead to runaway inflation, and we can't default, then we are not broke and we have the resources to do what is needed to get the economy moving again, give people jobs, continue to fund the social safety net, fix our infrastructure, invest in clean energy and energy independence - in other words to do what we have to do to release the creative capacities of the American people.


Amazing. More soon.