An alternative to popular faith
I’m searching for a way to explain that contrary to intuition and to what the media and politicians say, large federal deficits are good, not bad. Please read this and tell me whether you believe its clear enough for non economists.
The federal government is unique, far different from you, me, businesses and local governments. Its finances, particularly its deficits may seem counter-intuitive. You may have three fundamental questions about federal deficits:
1. Are large deficits unsustainable? Is there a time when the government will not be able to service its debts?
2. Do large deficits have an adverse effect on the economy?
3. Are large deficits beneficial?
Unsustainable: Visualize a scenario where there are zero federal taxes. The federal government has no income, yet sends you, “Mr. Lucky,” a check for $10 trillion dollars. You will deposit the check in your bank.
Will the check bounce? No. Your bank will credit your account for $10 trillion, then send the check to the Treasury, which will credit your bank and debit its own balance sheets for $10 trillion. You now have $10 trillion in your account, allowing you to buy a few thousand Rolls Royces or the State of Montana, whichever you prefer.
The government can debit its balance sheet and credit your bank, endlessly. The balance sheet is just a score sheet with a number. Whether that number is $10 trillion or $100 trillion makes no difference to the score sheet. The only limit is the artificial “debt limit,” on which Congress votes periodically. There is no functional limit on what any balance sheet can read. The government can write a check of any size, despite zero taxes.
Taxes may be levied for several reasons, but supplying the government with spending money is not one of them. The government creates money by spending. It does not use tax money. Therefore, all federal debt is sustainable.
Adverse effect: One possible adverse effect often mentioned is taxes. (“My children and grandchildren will have to pay for today’s deficits.”) But, we just saw that taxes do not pay for deficit spending. We are the children and grandchildren of the Roosevelt and Reagan eras. We never have paid for those monster deficits. The mantra about children and grandchildren is a myth.
A second possible adverse effect is inflation. Contrary to popular faith, inflation is not “too much money chasing too few goods.” That is an obsolete slogan. Today, we live in a world economy. Given sufficient money, there never can be too few goods in the world to sell. Instead, inflation is loss of perceived money value compared to the perceived value of goods and services.
The phrase, “too much money chasing too few goods,” addresses only supply. Inflation however refers to supply and demand, for money and for goods and services. The demand for money can change without a change is supply, and is related to interest rates. The demand for goods and services can change similarly, but generally increases when money supply increases.
Since we went off the gold standard, in 1971, there has been no relationship between deficits and inflation. In fact, the largest deficits have corresponded with the lowest inflation. See the graph, below:
Instead, inflation has corresponded with oil prices. See how inflation and oil prices move in concert, but oil moves much more, indicating oil prices are “pulling” inflation. (See the chart, below) Oil is the one “good” that can be in short supply and affect the prices of all other goods and services.
Despite the fact that large deficits have not caused inflation, I suspect there may be a point at which truly gigantic money supply growth could lead to inflation. We’re just nowhere near that point, as witness the current deflationary concerns.
At any rate, if inflation ever did crop up, the government would increase interest rates to increase the demand for money.
Beneficial: New York, a large economy, needs more money than does Peoria, a smaller economy. In fact, by definition, large economies need more money than do smaller economies. So for an economy to go from smaller to larger, its money supply must grow.
If you feel economic growth is beneficial, you also must feel money growth is beneficial. Federal deficit spending is the way the government adds money to the economy to make it grow. Federal deficits are beneficial.
Does this seem like it would be clear to the average person? What are your suggestions?
Rodger Malcolm Mitchell
2 thoughts on “–Another attempt to explain the positive effect of deficits”
It may be true that interest rates (i.e. what Treasury must pay for 10yr or 30yr funds) are of no consequence to the Treasury as they merely mark up numbers. However, recent poor auction results imply that long term rates may be on the rise and this does have an effect on mortgage rates which in turn effects (not the number of home sales), but the price of homes as they become less affordable with higher rates. This in turn puts even more pressure on bank balance sheets and generally favors creditors over debtors. No value judgment here, just an observation.
Jack you are correct. Higher interest rates mean more money coming from borrowers, but more money going to lenders. There are two sides to that coin.
Who are the lenders? People who buy CDs, Treasuries, corporate bonds, money markets and those who put money into bank accounts. On balance, I think there may be a minuscule benefit to the economy from higher interest rates, because they force the government to pay more, thus pumping more money into the economy.
Note that the government really never needs to borrow. They create money at will. So, they can set the rates at any level they choose.
Rodger Malcolm Mitchell