An alternative to popular faith

The Chicago Tribune reported, in its April 25, 2010 article “A tsunami of red ink,” that Isabel Sawhill, a senior fellow in economic studies at the Brookings Institution in Washington, gave five reasons why the federal debt is too high. Her reasons were: “higher interest rates, higher taxes, inflation, impact on foreign affairs and reduced flexibility in crisis.”

Sadly, these are common myths, based on intuition, not facts. Let’s examine each of these myths:

Myth #1: Federal deficits cause higher interest rates

Facts: In 1980, the Fed Funds rate was 15%. At the time, the federal debt was $800 million. Now, it is estimated the federal debt will reach $14 trillion by the end of this year – a 1,650% increase in only 30 years. Yet the Fed Funds rate has gone down, essentially to zero. How is this possible, if deficits cause higher interest rates? You have seen the repeated headlines “Fed lowers rates.” It is the Fed that sets interest rates, not the market for Treasury Securities and not the federal debt.

Japan’s national debt is proportionately 400% of ours, and they have a poor credit rating. Yet their interest rates are near zero.

Conclusion: Federal deficits do not and have not caused higher interest rates.

Myth #2: Federal deficits cause higher taxes

Facts: The government does not spend tax money. The government spends by crediting the bank accounts of its vendors. If you sell something to the government for $1,000, the government will reach into your checking account and credit it by $1,000, while debiting its balance sheet by the same $1,000. No tax money is involved. The government can do this endlessly. If taxes were reduced to $0, and the deficit doubled, this would not affect, by even one cent, the government’s ability to credit bank accounts.

So, what happens to tax money? It is destroyed and merely marked as a credit on the government’s balance sheets. There is no vault holding tax money. Ever since 1971, the end of the gold standard, government has had the unlimited ability to create money, i.e. credit bank accounts. Ms. Sawhill neglects the historical fact that despite the increases in federal debt, tax rates have gone down.

Conclusion: Federal deficits do not cause higher taxes.

Myth #3: Federal deficits cause inflation

Facts: This is only a partial myth. Some believe that once a nation reaches full employment, additional federal deficit spending can cause inflation. However, we are nowhere near that point. The highest inflation we have had in the past 30 years came in the first quarter of 1980 – about 14% – after which it began a decline to about 2% today, paralleling our government’s 1,650% debt growth. Two years after our highest inflation, President Reagan ran the highest deficits since WWII, while inflation declined.

Conclusion: Federal deficits do not cause inflation.

Myth #4: Federal deficits impact foreign affairs

Facts: Ms. Sawhill’s explanation is: “While it’s unlikely that a country like China, the largest single foreign holder of U.S. debt, would abruptly dump its stake in U.S. treasuries, its nearly $880 billion investment gives it a degree of leverage when the two nations sit down to talk trade, for example.” It’s hard to know what Ms. Sawhill means by “a degree of leverage,” but let’s examine the underlying principle.

Each nation, including China, has two accounts at the Federal Reserve Bank – a checking account (aka a “reserve” account), and a savings account, which consists of U.S. Treasury Securities.

When China exports its goods to us, it is paid in dollars. Those dollars are just credits to China’s checking account. Then, when China buys Treasury securities (which the government has created out of thin air), the Fed transfers the dollars in China’s checking account to its savings account.

Some people call that “borrowing,” but it actually consists of nothing more than a simple transfer of China’s own dollars from its checking account to its savings account.

When China’s T-securities mature, the Fed transfers the money (plus interest) from China’s savings account back to its checking account. That is the way America pays its debts to China. This easy transfer — nothing more than data entry — is not constrained in any way by the federal debt or taxes or by anything else.

If China wished to “dump its stake” in every single U.S. Treasury security, no problem. The Fed merely would credit China’s checking account and debit the account of whomever bought the securities. This has nothing to do with taxes, deficits or debt. The government can do this endlessly.

Conclusion: Federal deficits do not negatively impact our ability to deal with foreign governments

Myth #5: Federal deficits reduce flexibility in crisis

Facts: Ms. Sawhill explains this means it “constrains the federal government’s ability to respond to a crisis such as the September 11 attacks or Hurricane Katrina.” She forgets the historical fact that despite huge deficits, the federal government indeed did respond to these crises, not to mention paying for two wars and now paying to end the recession.

But, let’s discuss the underlying principal, which I suspect can be stated: “The federal government has a limited amount of money, and if it spends too much money on one thing, it can’t spend money on something else.” This relates to the myth that the federal government is like you and me. In order for us to spend, we first need to acquire money, either by saving or borrowing. The federal government is under no such constraints.

The Federal government does not have any money. It creates money by spending. As we said earlier, the government spends by crediting the bank accounts of vendors. This credit adds money to the economy. While the government has no money, there is no limit to the government’s ability to credit bank accounts.

If suddenly, a vendor presented the government with an invoice for $100 trillion, the government simply would credit the vendor’s checking account by $100 trillion, and debit its own balance sheet by the same amount. Done. There would be no need to increase taxes or to take any other action.

Conclusion: Federal deficits do not reduce government flexibility in crisis.

In summary, Ms. Sawhill subscribes to common myths about our economy, without providing any evidence as to her conclusions. She misinterprets the data, presumably because she wrongly believes the federal government is just like her – the “anthropomorphic principle — with limited resources and needing to acquire money before it spends. She fails to understand that the government is the issuer of the currency and she is the user. And she fails to look at the historical facts.

Rodger Malcolm Mitchell
http://www.rodgermitchell.com

No nation can tax itself into prosperity