Tag: cause inflation

–Isabel Sawhill and the Brookings Institution

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

–Nonsense from the Committee for a Responsible Federal Budget

An alternative to popular faith

Demonstrating the bankruptcy of the typical debt-hawk position, here are excerpts from a long Email I just received from the Committee for a Responsible Federal Budget, a leading anti-debt advocate.

“The current fiscal path of the United States government is unsustainable. For the past forty years, our debt-to-GDP ratio has averaged around 40 percent. This year, it is projected to exceed 60 percent, the highest point since the early 1950s. […] By the end of the decade, debt is projected to be 90 percent of GDP, approaching our record high of around 110 percent after World War II. Things will deteriorate further as the Baby Boom retirement accelerates. Ten years later, the debt is expected to be well over 150 percent of GDP. By 2050, it is projected to be over 300 percent and still heading upward.” Though they claim the “fiscal path is unsustainable,” they project all the way to 2050. The lowest (since WWII) Debt/GDP ratio of about 35% came 70 years earlier, at 1979-1980, the end of the Carter administration, which also was the time of the highest inflation

 

Deficits vs inflation thru 09

[…]It is not at all clear how exactly such a crisis would unfold – what would prompt it or how it would play out. A crisis could occur as soon as this year, or decades from now. It could begin inside or outside the country. The crisis could be dramatic or gradual. It could come from an economic or another financial shock, or even a political surprise.” In short, “We don’t know when; we don’t know how; and we don’t know what. Otherwise, we’re sure.”

“Experts agree that we will be in a crisis when we can no longer service our debt obligations. However, we will probably never face this scenario.” This is the first time I ever have heard a debt hawk make this admission, which the author repeatedly forgets, later in the Email.

“There are a number of different crisis scenarios: Scenario 1: The Gradual Crisis – We stay the current course and try to muddle through. Our massive borrowing leads to less capital available for productive private investment, which lowers economic growth.“ Federal deficit spending adds money to the economy. There is no mechanism by which added money can reduce the supply of capital.

“Increasing debt service payments – particularly when interest rates return to normal – squeeze out other areas of the budget. The steady crowding out of government spending on programs that boost the economy, such as spending for education, infrastructure and innovation, will hurt our competitiveness.” This crowding out only can happen in a debt-hawk world, where deficits are restricted, either by tax increases or by reduced spending – a self-fulfilling prophecy.

“Scenario 2: The Political Risk Crisis – Political calculations trump risk threats. […] As a result, more budget resources are shifted from children to seniors, and from investment in programs boosting future growth. […] creditors lose confidence in U.S. fiscal management. Our creditors increasingly demand large risk premiums on purchases of their debt, sharply lower their purchases of our debt, or, in the worst case, stop buying our debt if the shift occurs suddenly. Credit ratings agencies lower our sovereign credit rating.” This neglects the simple fact that since the end of the gold standard, in 1971, the federal government no longer has needed to borrow its own money. Rather than borrowing by creating T-securities out of thin air, then selling them, the government can and should create money directly, and omit the borrowing step.

“Scenario 3: Catastrophic Budget Failure – An abrupt crisis occurs. […] at some point financial markets or foreign lenders decide we are no longer a good credit risk, possibly due to debt affordability concerns.” Debt affordability? Didn’t you just say,” Experts agree that we will be in a crisis when we can no longer service our debt obligations. However, we will probably never face this scenario.”

“[Creditors] stop buying our debt securities or demand dramatically higher interest rates due to increased perceived risk. […] In the extreme case, the U.S. may not be able to borrow at any interest rate.” Creditors concerned with hyperinflation or even default will not buy U.S. debt.” As we said, the U.S. no longer needs to sell debt. Issuance of Treasury securities could end today, and this would not change by even on penny, the government’s ability to spend.

“Scenario 4: Inflation Crisis – Higher debt is managed through inflation. […] Under strong political pressure, the Fed […] does not raise interest rates despite signs of increasing inflationary pressures. […] Fiscal consolidation will require spending cuts that will hurt safety net programs. Business investment incentives will disappear and tax rates will rise, as policymakers search for revenue. Household taxes rise and government services are reduced.” Wait. Isn’t that exactly what you are preaching – spending cuts and tax increases?

“Scenario 5: External Crisis -A dollar or trade crisis leads to a fiscal crisis. When the economy recovers in a few years, our current account deficit (which had narrowed during the recession) resumes widening to record levels. […] Capital inflows slow abruptly as investors see better risk-return opportunities elsewhere, decide the risks of the U.S. market are too high […] A sudden stop in lending lowers the dollar, increases inflation and interest rates[…]” A widening of the current account deficit means dollars leave the U.S., which if anything, would be anti inflationary.

“Scenario 6: Default Crisis – A series of events lead to a default.” Once again, you already have said the U.S. will not default.

“[…] Our need to pay higher interest rates increases debt service and crowds out public and private spending. […]” Higher interest rates increase the amount of money in the economy which facilitates private spending.

“[…}A new administration defaults or attempts to renegotiate our debts. Burned creditors stop buying U.S. debt or demand onerous interest premiums.[…]” Again, defaults? You’ve already discussed this impossibility.

“Countries that have sufficient domestic savings to finance their debt are less vulnerable than those that must attract considerable foreign capital – such as the United States. ” Totally false. The U.S. does not service its debt with savings. It creates money, ad hoc, to pay its debts.

“[…] Our large trade deficit outlook is considered unsustainable and a likely crisis flash point.”You already have admitted U.S. has the unlimited ability to service its debts. So what do you mean by “unsustainable”?.

“Some top economists argue that the U.S. can “afford” even more debt awhile longer because its debt service will still remain quite manageable. They also expect that the United States can avoid adjustment longer than fiscal policy norms might suggest because the dollar is the world’s reserve currency.” The debt service is manageable, not because the dollar is the world’s reserve currency, but rather because the government has the unlimited ability to pay its bills, and does not need to borrow.

“While certain countries are often cited to show that high sovereign debt ratios can be sustained without crisis (Italy, Belgium, Japan now), these countries – unlike the United States – can finance their debt through their substantial domestic savings.” Government debt is not financed through private savings. You and I do not pay federal debt with our savings.

“Many governments facing similar circumstances to the United States over the next generation have tried to avoid fiscal adjustment by running higher inflation to reduce their debt burden. Though appealing, this strategy hurts the economy and its citizens (particularly those on a fixed income).” There ever is a reason for a sovereign nation, in control of its money, to reduce its debt through inflation.

The entire premise of the Committee for a Responsible Federal Budget is that buyers of T-securities control the fate of the U.S., when in fact, the U.S., as the creator of dollars, no longer needs anyone to buy T-securities. This lack of understanding would be amusing were it not for the fact that the government acts on these beliefs.

One of the reasons we have been so slow to exit recession, is the government’s timid stimulus responses. The too little / too late, initial $150 per person mailing two years ago was restricted by debt fear. A $1,000-$2,000 per person mailing at that time, would have ended the recession.

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

–Watch Ben Bernanke’s high wire balancing act

An alternative to popular faith

April 14, 2010: By JEANNINE AVERSA, AP Economics Writer; WASHINGTON – “Federal Reserve Chairman Ben Bernanke […] testifying before Congress’ Joint Economic Committee, also once again called on lawmakers and the White House to come up with a plan to whittle down record-high budget deficits.”

Ben Bernanke is a smart man. He knows federal deficits are nothing more than a balance sheet measure of money created by the federal government. He knows the $12 trillion debt merely is a statement that in the history of the United States, the federal government has created $12 trillion net dollars. He knows that to “whittle down record-high budget deficits” is another way to say, the government should create and spend less money.

But also knows the federal government cannot default on debts of any size, and creating and spending money stimulates economic growth. So, he favors continuing federal stimuli (aka deficit spending).

If you think that is a mixed message consider this: He said, “A credible plan to pare the deficit could provide the economy with benefits in the near term, including lower longer-term interest rates and increased consumer and business confidence.” And, “A moderate U.S. economic recovery is likely to warrant very low interest rates for a long time.”

First, he says the deficit should be reduced in order to lower interest rates. Then, he says the Fed will keep rates low for a long time. Question: If the Fed can keep interest rates low for a long time, why does Bernanke need a plan to whittle down deficits?

Is it to avoid inflation? There is widespread belief that large deficits cause inflation, despite history saying otherwise. See: Deficits, inflation and hyperinflation And though raising interest rates prevents and cures inflation, the Fed believes it must keep rates low to “increase consumer and business confidence.”

What’s a guy to do? He keeps rates low and deficit spending high. But, he knows the public believes deficits are too high (This is the same public that wants neither tax increases nor to forgo the benefits stimulus spending buys. It wants a magical deficit decrease.) So Bernanke, by seeming to agree with the public, takes the political route, saying in essence, “Those high deficits aren’t my fault. Blame Congress and the President. I’m just doing what’s necessary to help the economy,” (which, don’t tell anybody, means running big deficits and keeping rates low).

The balance is not between what’s good and bad for the economy. That’s the easy part. The balance is between what’s good for the economy and what’s good politically. They are quite different, and the high wire balancing act is tough.

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


–Are we inflating our way out of debt?

An alternative to popular faith

Some experts tell us the federal government wishes to “inflate its way out of debt.” The theory is this: During inflation, money loses value. For instance if the buying power of tomorrow’s dollar will be worth only 90% of today’s dollar, paying today’s $1,000 debt tomorrow will cost you only $900 in today’s buying power.

That is why, if you positively knew inflation will average 3%, borrowing money at 2% would net you more buying power than you have today. This was part of the lure of home ownership. Real estate inflation would make your house appreciate faster than your interest payments – an automatic profit.

Let’s say you have no money in the bank, but you are able to acquire a $100 thousand, low-interest-only mortgage to buy a house. The house inflates in value 10% a year. Ten years after buying the house, you could sell it for $260 thousand. You could pay off your mortgage principal and have tons of money left over. In essence you have inflated your way out of debt and made a profit, a nice, no-effort game, that millions of people played.

It’s a philosophy that, during inflation, can work for people, companies, and state and local governments, but not for the federal government.

You see, the federal government creates all the money it needs, to pay bills of any size. Unlike state and local governments, the federal government does not rely on taxes or any other income to pay its bills. If all federal taxes ended today, the federal government’s ability to pay its bills would not change by even one penny. No federal check of any size would bounce.

When you receive a federal check, you deposit it in your bank account. Your bank sends the information the government, which unfailingly credits your account. This credit to your account is not related in any way to taxes, inflation, balance of payments, T-securities or to any other economic reality. The federal government does not maintain a stash of dollars from which it pays bills. It merely creates money by crediting bank accounts. This may sound “too-good-to-be-true” or a “free-lunch,” but it’s the way federal financing works.

Further, the government owes virtually all its debts in dollars, which makes inflating useless. One trillion dollars in debt must be repaid with one trillion dollars, neither more nor less, regardless of inflation.

So the question is: If the government can pay any bill of any size, simply by creating all the money it needs and crediting bank accounts, and if no federal check ever bounces, why would the federal government need to “inflate its way out of debt”? The answer: It doesn’t.

Anyone who says the federal government wants to inflate its way out of debt simply does not understand the reality of federal government finance. They probably have confused federal debt with all other debt.

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