Thursday, June 2, 2011

Why government deficits are healthy and normal, especially after a fall in demand

Not a day passes by when we don't encounter someone writing that government should cut its budget and start balancing it. This post will add to the body of posts arguing that a government committing to austerity is exactly the wrong policy to enact during a deleveraging and during a general fall in aggregate demand. Since posts calling for austerity and balanced budgets are just reiterating the same points again and again, I will reiterate points I've already made earlier. This post leans 100% MMT.

All income in the economy is money that has been borrowed into existence by someone lese, or else spent into the economy by government. There's no other way for fiat money to come out of thin air. Nobody in the private sector suddenly becomes wealthy, without having gained his wealth from somewhere. Trace every unit of this money all the way to its origin, and you eventually get to a point where it was either created by someone's debt, or by an act of government spending. Government spends money in paying citizens to defend its borders, police its citizens, teach its children, and the various other duties in running the state. Someone takes out a loan from a bank, with a promise to pay it back at some future date, and the bank raises this money from the central bank, which credits the fiat.

A growing economy creates the credit and demand growth necessary to sustain itself without government deficit spending. Conversely, in a depressionary environment, where people are conserving income, credit is withdrawn, and demand is therefore withheld from the economy, we need government to step in and fill the spending void left by the private sector saving. Not to do so would lead to private incomes being destroyed, due to withheld demand, which leads to a vicious spiral of more people not spending, and more demand being withheld from the economy.

And yet, experience shows us that government spends more during a boom than on a depression. They do so because they think of themselves as merely sharers of the currency with the private sector, rather than its issuer. So they spend when they think they have the tax funds, and refuse to spend when they lose the tax base (Though by jumpstarting spending in the economy is precisely how they will recharge the tax base).

There is a stable level of government deficit that promotes growth. It's a deficit level just large enough to create private incomes to make private businesses stable, and willing to hire more people, and thus leading to a positive spending multiplier. Since government spending becomes part of GDP, every $1 of government spending leads to at least $1 of GDP. In order that debt does not grow faster as a percentage of GDP, there should be a positive multiplier effect. So government needs to be careful what it spends money on. A good expenditure would be giving jobs to the jobless providing community services that are currently lacking. This is not a handout, because those not willing to work will not get anything (Thus no inequitable distribution of society's bounty). Without government spending, where would the growing incomes to power private spending initally come from? The state's option to be able to spend more, in place of disappearing private spenders during times of escalating private sector desire to save, is an invaluable lifeline during a severe depression.

Without a growing government debt, there can't be growth in GDP. Government debt constantly grows because when government spends more than it takes in revenues, as during recessions, it's always forced by law or charter to borrow. This is a relic of the time when all its payments in currency need to be backed by gold. Now that the gold standard is long gone, this charter is obsolete. The mechanism to fund deficits could be by purely printing fiat money. If Treasury just credits the bank accounts of fiscal beneficiaries, it can spend without having to raise money via borrowing through the Treasury market.No more need to decide whether to borrow, because the borrowing issue just muddles the issue, and gets people to focus on the debt level rather the efficacy of what the government is spending on. Once countries had decided to let go of the gold standard, they acquired the capability fund government spending by merely issuing more currency. What's now left is for the law, and custom, to recognize this.

P.S. I just want to add this point, for those who fear that increasing government spending will lead to inflation. The point is that there would be no inflation if the private sector is avoiding to spend. Inflation will only arise if there was already a lot of private sector demand, and the government is stepping in to add even more to it. If there's no demand, there'll be no inflation. In fact, if the demand is falling, there would be deflation. Unless someone steps in to fill the void. Same goes for those who fear a crowing our of private sector. No private sector demand, nothing to crowd out. Would that it were true that there was something to crowd out, we wouldn't even be talking about the need for more government deficits.

follow up posts here and here.


Mario said...

yup. It's all true...people for whatever reason personal to them and their beliefs just don't seem to like it that way...when in fact it is a rather seamless monetary system if I do say so myself. ;)

"experience shows us that government spends more during a boom than on a depression."

This actually leads me to believe that our government spending in booms is possibly even more a contribution to building bubbles than the Fed 0% rate policy ala Greenspan or whoever. Lack of common sense regulation & tax subsidies (similar to government spending however) of course also contribute too.

Thanks again for sounding the alarm for all to hear...that 100th monkey is around here somewhere I swear!!!!!

Rogue Economist said...

Mario, we all do what we can to sound the alarm. Maybe one day they'll all hear.

Mario said...

yup. I do believe that it will happen...eventually. The call will be just might happen in 50 years or more or tomorrow who knows these days. History/Time can be a bitch like's on your side but not necessarily on your time. LOL ;)

Detroit Dan said...

Well said. I'll save this for future discussion, as it's an improvement in some respects from the way I typically express MMT concepts...

Hans said...

I have a healthy mistrust of the working concept of MMT..(

You stated, Mr Rogue, "without a growing government debt, there can't be growth in GDP."

However, since the end of WWII, there were five fiscal years wherein Federal debt declined and with a position GNP.

1948 (4.4%), June 1950 to June 1951 (7.7%),
1957 (2.0%), 1960 (2.5%), 2000 (7.1%)

Mario said...

Hi Hans,

glad to hear you are skeptical. I do agree with your point in fact, and I am someone that subscribes to the MMT fundamentals. Mr. Rogue made a common error in his statement about GDP for an economy. Not all economies need to run deficits to have positive GDP or positive private Net Financial Assets (nfa). It is b/c it depends on the savings, tax structure, and current account (aka demand leakages) of that economy. It is possible to envision an economy that is running a surplus in the public sector AND also a private sector surplus. It just depends on the tax and savings desires (and unemployment levels) as you aptly point out in your stats. An economy that is a net exporter would already have a surplus in the current account and so one could see that government spending (public deficit) could very well only over-inflate the economy even further and be overkill. Since the US now has a current account DEFICIT (we are net importers) it is rather obvious that we need to run a public deficit so as to counter-act that nfa drain in our economy. Some people misspeak and think that b/c MMT advocates a government deficit for the US that MMT ALWAYS believes in a government deficit. This is not the case nor is it accurate.

If you check out Bill Mitchell's blog at you will see much more discussion of this sort there in nothing short of real economic terms.

I'm not an economist so I can't get fully into the details with you as of yet without feeling a bit out of my league, however I do know that I've read in Bill's blog and weekly quizzes that the level of government deficits (or surpluses) in an economy seeking to reach full employment varies and depends on the nature of that economy. True MMT economics is NOT wedded to government deficits but rather to FULL EMPLOYMENT at whatever the cost for a monetary system that has a non-convertible floating exchange. ;)

I hope that helps you and clarifies some concerns you may have had with MMT.

One question for you...I read the article you linked to...what do you think is the distilled reasoning that he is using to refute MMT? I read it and am having trouble finding the actual refutation in the article.

Thanks for speaking up and good luck on your quest for economic truth! ;)

Mario said...

sorry the link to Bill Mitchell's blog is here:

Rogue Economist said...

Hans, that's right. When GDP is growing while government debt is going down, it might be that private sector is increasing debt. If private sector debt isn't growing either, then the country is likely incurring trade surplus, therefore, their savings are being funded by some other country's government spending or private sector debt.

The dates of your example seem to coincide when thte US was the only country in the world with a significant productive capacity (this was just after WW2) do everybody else was buying more from it. In any case, the question to always ask is where is the money to grow the GDP coming from. It has to come from someplace. Always, someone has to be spending more than saving, for there to be more spending going on in the aggregate economy.

Hans said...

Too much text and when I try to edit (after several attempts) I lost the entire post...

Will try later, as I just got the two minute warming!

Thanks Mario and Mr Rouge!

Mario said...

yeah I hate when that happens. I always copy and paste my text comments before I post them for that very reason. ;)

Steve said...

If there is no private sector demand, and the government doesn't spend more and increase demand. Yet, China increases prices (say they have domestic demand) won't this still be inflation or are you using inflation as an Austrian would?

Also, I don't quite understand the boundary conditions of MMT. Surely, the government could monetize the entire debt today a few trillion for government savings and a few trillion for private savings as a sweetener. Presto everyones saves at the same time at the expense of current dollar holders. Yet you talk as if, this could only happen with a trade surplus. Are you saying this is a trade surplus because it devalues dollars held in China.

If that is the case, it seems like a default of government and private debt accomplishes about the same thing with about the same victims.

But I don't think this is what you are saying. Are you saying the government is restricted from monetizing or just shouldn't. If it doesn't and we continue a trade deficit couldn't the government simply be forced to default or monetize at some future date because it can't pay the interest.

Mario said...

Hey Steve,

not sure I understand you. China was spending like crazy and they are dealing with inflation now.

Why would the government monetize its own debt other than through ordinary maturity? To my understanding, MMT recognizes that treasuries are essentially as good as cash and really represents saving desires (that likely will not stop--i.e. bond savers won't be liquidating and buying flat screen TV's with their investments!! LOL). This is also why MMT recognizes that QE is essentially meaningless for the economy (in fact it takes away interest payments to the private sector!). To hold tsys is essentially to hold cash. Private Net Financial Assets are growing. From the government's pov, their bonds are simply liabilities that always can be paid off due to the non-convert floating exchange. It's not a big deal. China doesn't fund it nor does anyone else. We fund ourselves...even when we don't know it! ;) Therefore you can consider that all treasury holdings are "already" liquidated for those investors. They are as good as cash + interest. Also the degree of savings desires (just like the degree of the current account) in an economy can also indicate the degree of government spending necessary to offset any private sector "taxation."

I am not sure if that addresses your question? Rogue should probably be responding to you not me (and correcting me wherever I am off here!!) since it's his blog not mine!! Sorry Rogue!!!

Rogue Economist said...

Mario, thanks for helping address comments. You're always welcome because your points are similar to mine (well, since we both lean to the MMT position)

Steve, not sure what your question is but here's a possible answer:

Peter, Paul and Mary comrpise an economy. Peter wants to save more today so he can spend more tomorrow. This leaves Paul, who usually sells his service to Peter, with no income to buy his meal from Mary. Therefore, both Paul and Mary go incomeless and all spending in the economy come to a halt. It may not even come back tomorrow when Peter plans to spend because he's now afraid to part with his money, given the lack of spending by anyone else. It is now up to the government to buy Paul's goods so he can buy from Mary, and she can buy from Peter, and the cycle can go on.

Now let's say Han is a foreigner trying to sell to the 3 of them. He sells enough such that there is no longer enough income between peter and Paul to buy anything from Mary. So the government steps in to buy from mary so she can then continue buying from Peter and Paul, and continue the cycle. Who will buy the government's bonds to finance its spending on Mary? Han. Because he now has extra money that he needs to put somewhere.

Min said...

Mario: "Why would the government monetize its own debt other than through ordinary maturity?"

My question is, why would a gov't debitize its money?

Mario said...

it's a good question. There are some MMT people that call for no bonds!!! LOL

Personally I look at it as a savings account. Functionally there seems to be no reason to issue bonds any longer.

In fact I am beginning to wonder if bond issuance can pose a threat to that currency's depreciation if one bond holder (like China for example) were to liquidate and/or stop purchasing our bonds. I am really still not sure about the exact and precise relationship between bonds, currency, and the capital account...Rogue could you explain that a bit maybe? Here's a quote that I read here at this article over at credit and quote are both below. If anyone can explain this quote to me more fully I'd be soooo grateful to understand it and learn more about it.

Thank you!

"By the middle of the decade at the latest, we will have a major crisis, bigger than 2008. Several countries will default, particularly in Europe. Quasi-fixed exchange rates between the U.S. and China will start to unravel, which will force the U.S. dollar down tremendously. It will push bond yields up and stocks down.”

Mario said...

in other specific question is:

Why would the unraveling of the "quasi-fixed exchange rates between the US and China" push the US dollar "down tremendously"?

why is that? What forces are at play in that move?

That's my question. I am suspecting that it has something to do with the fact that the US runs a capital account surplus (imports more than exports), that China buys our bonds with their US cash earnings from their export sales, and that in order for this quasi-fixed exchange to unravel China would be forced to liquidate their US bond holdings and/or stop purchasing US bonds. I don't know if that's accurate, I am just thinking that these may have something to do with it. If China wasn't a buyer of US bonds anymore (or at least a far smaller buyer) that would explain why bonds would go down (rates go up) b/c there would be a need to attract more buyers to the US tsy market and higher rates would ensue, which would then possibly create a "risk-off" scenario in equities, however that may or may not be the case b/c the market may view higher rates as a positive sign of US growth (aka less "debt" to pay off so the nation is "healthier" now) and instead an equities rally and increase in capital investment would ensue. Don't know about that so much and don't really care...more interested in the currency and bond relationship at this time.

However I don't see how that US-China currency peg unraveling would result in a major drop in the US currency. I guess I am not seeing the relationship between foreign holdings of US bonds and the currency. I do realize that bonds generally track inflation and/or the Fed Funds Rate though, however this seems different to that.

Any help on clarifying this would be much appreciated.


Rogue Economist said...

Mario, a likely explanation is that when foreigners buy US bonds, they buy US currency. When this stops, they stop buying US currency, so it will likely go down in value vs other currencies.

Min, I have no idea why a government will want to monetize before maturity. There's just no need to. Even QE2 had other primary objectives (to stimulate lending and investment) rather than to monetize the debt. It'll only monetize debt when debt matures and it no longer wants to borrow or use tax proceeds to finance it.

Mario said...

that makes sense rogue. Thank you.

this means then that if the US wasn't the world's reserve currency then our dollar would be far lower.

This also means then that China plays no small role in keeping afloat the US economy.

This to me seems like a major concern for the US economy don't you think? I mean a far weaker dollar does not sound good to me and I can't imagine how exporting more would help us in this regard. It would appear that importing supports us in counteracting these depreciation concerns no?

Is this accurate and if so is there anything else the US can do to protect itself from such a serious depreciation from occurring?

Rogue Economist said...

Mario, I don't think a depreciating currency would be all that bad. It will have downsides, yes, but I don't think maintaining the imbalance caused by an overvalued dollar and ROW willing to save in USD is a good idea. The US will have to learn to manufacture more stuff locally again.

Mario said...

hmmm interesting points Rogue.

The only thing is I am a rather international individual and I don't like a worse exchange rate for myself. ;)

Nor do I like the idea of myself making "less" money in that sense of the word.

After this yuan "unraveling" is all said and done where do you suppose the US $ really stands?

where do you think it would really stand if it wasn't the reserve currency any longer? Do you think that would really happen in full force only if/when the oil is no longer priced in US $?

Cheers mate and thanks for the food for thought. It would be cool if the US got more into local, sustainable, organic, and healthy production and manufacturing of goods/services...but that's the hippie/health boy in me coming out. ;) I really do suspect that in the long run these 3rd world nations in Africa and Nepal and India will be far ahead of us "developed" nations once they get educated and learn how to sustainably industrialize and manufacture products and economically and ecologically use their land and resources...they will be ahead of all else by far and away imho. Cheers mate

Rogue Economist said...

I'm thinking if the USD depreciates, more foreigners will invest in the US. Why wouldn't they, when their money can go further. It wouldn't be because of the reserve status anymore, it would be fore real opportunities.

About your international status, well, you might have a bit of decrease in income in forex terms, but probably not as bad as you'd think, barring any Fed-induced devaluation.

Mario said...

that's true too. In fact if I am not mistaken, many foreigners came over after the GFC and bought a number of nice homes on the cheap, etc. Interesting food for thought.

one way or another, America is in for some C-H-A-N-G-E-S!!!!

Mario said...

hey Rogue,

just fyi I passed similar questions over to Warren Mosler on his site regarding the US dollar, China bond purchases and the yuan-US peg and he responded thus (I figured you might be interested to hear his thoughts):

"yes, any seller of dollars would be a force that drives the price down while they are selling.

and yes, if China and dropped the peg the presumed yuan appreciation vs the dollar would be a falling dollar as well. Same thing.

but the question is whether this would alter the term structure of US risk free rates, and the answer is not much, if any.
and the further question is whether the fx value of the dollar is a function of rates and again, my answer is not much, if any (apart from shorter term knee jerk type trading reactions)

Nor does China need to keep buying our bonds to keep our currency up"

the link to the article + comments is here:

Rogue Economist said...

Mario, Warren's right. China doesn't need to keep buying US bonds to keep USD up. All they need to do is keep buying USD. And that's what they do every time they end up with trade surplus with the US in USD.

Mario said...

ahhhh I see. So the very fact that we have a trade deficit makes our dollar stronger...that makes sense of course too. So then as long as China keeps selling us stuff (and we keep buying it) our dollar will stay up...and even if the yuan-US peg is lifted, like you say, we may see a bit of depreciation in the US dollar, but really as long as China keeps selling, the US dollar will still be up. However of course if the yuan peg is lifted it is possible that China may not keep selling so much so that could be an issue for us down the road, which explains that guy's reasoning. Nice. ;)

I'd rather see the peg stay in place, we continue to run a capital account, and we just get more MMT-like in our fiscal approaches here at home...then we can have our capital account and nice employment and wealth levels here at home and a nicely strong dollar. How long can that last? Well I didn't see China wanting to change the game plan anytime soon...only this admin. with its drive to become an exporting nation.

Thank you Rogue rock on brotha!

Rogue Economist said...

Mario,the dollar keep strong only if, and this is important, China's trade surplus is in USD. That means continuing demand for USD.

The irony is that, only when the US becomes MMT, and print dollars as needed to fund trade deficits while keeping local employment up, will the Chinese see the error of their ways and abandon the peg. They maintain the peg despite just getting what to them are useless not-to-be-spent USD to keep their own employment up, you know.

Mario said...

ahhh I see...nice clarification there...thank you.

I would think china is okay with this scenario since they are getting nice enough returns on their huge amount of surplus dollars...they have more than enough inflation as it is in their own country so they surely would be holding all that cash somewhere in the world other than in their own why not in the USD!?!?

I would hope that we could have an MMT-esque fiscal structure here and still keep our dollar up and China happy as is. ;)

You are the man thank you for lending me a hand in this fascinating realm. I love this stuff and can't thank you enough. Cheers mate!

Hans said...

Mr Rouge said "The dates of your example seem to coincide when thte US was the only country in the world with a significant productive capacity (this was just after WW2) do everybody else was buying more from it. In any case, the question to always ask is where is the money to grow the GDP coming from. It has to come from someplace."

This was true for all the dates indicated with the exception of 1960 and 2000, both of which did not enjoy a trade surplus...

Besides the fact that most government spending is viewed, in my pea brain, as waste the only time they should be operating at a deficit is when the economy is in recession...

I am sorry for the delayed response, Herr Rouge...

Mario, I will reply to you next...

Rogue Economist said...

Mario, I think China's main concern, rather than having a nice return on investing the dollars, is that their dollars do not fall in value vs other currencies. I don't think they're too happy with what happened, which is just as well. They should have spent that money in the US long ago.

Hans, I replied to you in the other thread.

Mario said...

interesting Rogue very interesting. I see what you mean. I think we are all beginning to learn that no investment just goes on "forever" eventually you have to move funds around and re-allocate your positions to maximize your returns and value. Makes sense to me. cheers