Obama’s Implausible Dream: Cut the Deficit without Destroying Jobs

By Stephanie Kelton

White House Press Secretary Jay Carney recently explained President Obama’s “singular concern, which is that the outcome of the deficit reduction talks produce a result that significantly reduces the deficit while doing no damage to the economic recovery and no damage to our progress in creating jobs.”

Great. And I want to go on a donut diet and shed ten pounds.

As far as Washington is concerned, there are only two ways to bring down the deficit: cut spending or increase taxes. Both reduce private sector incomes.  This means that the president is looking for a way to reduce private sector incomes without hampering sales or job creation.

Can it be done? Let’s see.

Suppose the government decides to cut spending by $100. This means that someone in the private sector is receiving $100 less than they were getting before the government tightened its belt.  Ordinarily, we would expect this to generate an even bigger drop in GDP, as the decline in income leads to multiple rounds of contraction due to the effect of the multiplier.

For those that need a refresher, the multiplier is given by (1/1-b), where b = the marginal propensity to consume (MPC) or:

It shows the relationship between disposable income (Yd) and household consumption spending (C). As disposable income increases, we expect household spending to rise, making the value of the MPC > 0. But we also expect people to save a bit more, so the MPC < 1.

This means that we also have a marginal propensity to save, which is given by:

The MPS shows how saving changes in response to a change in disposable income. Like the MPC, the MPS is expected to be greater than zero but less than one. And, since you can only do one of two things with your disposable income – spend or save – the MPC and the MPS must always sum to 1. This is all basic Econ 101.

So let’s suppose that the MPC = b = .90, which means that people tend to spend, on average, $0.90 out of each additional $1.00 of income they receive. The other $0.10 is added to their savings. Now suppose that the government reduces its spending by $100. What will happen to economic activity as measured by output (Y) ?

After multiple rounds of spending reductions (the multiplier at work), output falls by $1,000. Ouch!

But the president is looking for ways to reduce the deficit without damaging the recovery or destroying jobs. So maybe a tax increase is the way to go. Let’s check.

A tax increase means less disposable income , and this means less spending by consumers. As before, a reduction in spending by one party (in this case the private sector) will result in several rounds of additional cuts, because of the multiplier effect. We can use the following equation to measure the macroeconomic effect of a change in taxes.

The large bracketed term is the tax multiplier, and it is used to demonstrate the macroeconomic effects of an increase/decrease in taxes. Since the president is trying to reduce the deficit, we should consider the effect of a $100 increase in taxes. If the MPC = b = .90 as before, we get:

In this example, output falls by $900, better than the previous outcome, but still not what Obama is looking for. So the challenge remains: How can the government reduce the deficit without negatively impacting economic activity?

As Warren Mosler pointed out, it would require Congress to tax where there is a negative propensity to spend and cut where there is a negative propensity to save.

What does this mean? A negative propensity to spend means that people would spend more if the government raised taxes and reduced their incomes:

Under these circumstances, the economy would benefit from, say, a $100 tax increase, because households would spend more even though their incomes were falling:

Similarly, if the government cuts spending where there is a negative propensity to save, then output and employment will increase even as the government tightens its belt.

But a negative propensity to save means that the MPC >1 because the MPS < 0 and they must sum to 1:

Under these conditions, a $100 cut in government spending results in:

But what are the chances of this happening in the real world?  Probably zero. Spending cuts and tax increases reduce private sector incomes.  And the private sector isn’t going to celebrate the loss of income by going on a shopping spree.

The bottom line is this: As long as unemployment remains high, the deficit will remain high.  So instead of continuing to put the deficit first, it’s time get to work on a plan to increase employment.

Here’s the formula: Spending creates income.  Income creates sales.  Sales create jobs.

If you think you can cut the deficit without destroying jobs, dream on.

28 Responses to Obama’s Implausible Dream: Cut the Deficit without Destroying Jobs

  1. You can cut the deficit and create jobs. Just not by cutting spending or increasing taxes. But fiscal stimulus would increase output and jobs, and by raising revenues, it may actually reduce the deficit.

  2. Yes, that is the point. The deficit is a reflection of what's going on in the real economy. Improve the real economy, and the deficit will come down on it's own. But you have to make job creation the priority. But Obama needs to accept the fact that the deficit needs to rise before it can safely fall.

  3. Stephanie,I'm getting dumber and dumber about all this, but appreciate your really simple explanations (like the belt-tightening two-parter). The above makes my eyes glaze over. . . . . . . Mainly because I am stuck trying to make all this jibe with whatever Clinton did by "balancing the budget" during the 90s and the surplus in 2000.Is it because I am confusing debt and deficit? Is it because I am just plain dumb, or what? {Thankfully, I'll be able to identify myself only as Anonymous here.]

  4. You're not dumb! I just decided to use some conventional macro to demonstrate the conditions under which a fall in government spending (G) or an increase in taxes (T) would lead to a rise in output (Y) and employment. Forget the math. Trust your instincts. If the government buys less, someone ends up with less income. How do you think they'll respond? If your income went down, would you buy more goods/services or fewer?If the government raises taxes, people get to keep less of their income. How do you think they'll respond? Now, let's talk about the Clinton years. The private sector went nuts. Debt-to-income ratios exploded as the private sector took on more and more debt to finance .com endeavors, etc. The surplus was a reflection of what was happening in the real economy (unemployment fell to 3.7 percent or so). But as Wynne Godley always said, this an unsustainable position for the private sector.Or, as Warren Mosler says, "The 1997-2001 budget surplus was the longest surplus since the 1927-1930 surplus. Coincidence?"

  5. I'd also introduce terms such as marginal propensity to borrow and marginal ability to borrow. Labor share of income or output — or whatever the actual term is — declined for 2-3 decades but consumer debt increased so spending increased. So it seems to me that in theory consumption could still grow but in practice with high unemployment and falling house prices pigs will fly before people take on more debt (to fund consumption).

  6. This was great, but you lost me in the "negative propensity to spend" section. Wouldn't those with a "negative propensity to spend" have incomes high enough that spending wouldn't change (they would just save less)? In that respect, you are "taxing" the right place because GDP stays constant while the deficit goes down? Did I miss something?

  7. I'd love to see a jobs pledge to counter the conservative tax pledge- something to the effect of: "No policy should result in a net loss of jobs- any police that directly or indirectly results in the loss of jobs must be offset by one that directly or indirectly creates at least an equal number of jobs at the same or better compensation"–I'd think that it is actually possible to use tax increases to encourage spending by pairing those increases with deductions for said spending; effectively a non-consumption tax. If you only tax unspent income (by, basically, allowing all spending (on goods, services, and capital investments, count financial investments and the like as savings) to be deducted from income, then a stiff tax rate on the excess should actually encourage people to spend more quickly to retain more of that value.

  8. Stephanie, I'm the June 17, 2011 7:17 PM Anonymous,Thank you for the reply. I had NO IDEA about this: "Or, as Warren Mosler says, 'The 1997-2001 budget surplus was the longest surplus since the 1927-1930 surplus. Coincidence?'" Although, since you're thorough, you might have mentioned it in the two-parter.I can't remember whether it was you or Bill Black who said we've had seven surpluses in US history followed by seven recessions.Just want to say I find your writing valuable. I'm slowly getting educated about the economy in a way that makes real-world sense.Thank you.

  9. You've shown that deficit reduction by whatever means is detrimental to the economy. If we had thoughtful political leadership, not hurting the economy would be Plan A. However, I think we have to accept there will be no Plan A and we will get a Plan B – which is the economy takes second place to politics. It seems to me who's spending is cut and who's taxes are raised is going to be the issue.Your analysis of the effects of deficit reduction shows that reduced government spending and tax increases are quantitatively different. Under your assumptions (above) spending reductions are more damaging than tax increases.In the event that deficit reduction is the only politically viable outcome at this time, it seems that we the people should hope President Obama negotiates for a greater emphasis on increased taxes. Further, your assumptions above assume on average effects resulting from tax increases. My question is – Aren't MPC an MPS different for people in different income brackets? If tax increases are weighted to have a greater effect on high incomes, wouldn't they have a smaller effect on consumer spending reduction compared to the same amount of tax collected from low income earners? Thank you for your clarity and efforts in presenting the way the economy works. You have helped me to become (I hope) a better and more informed citizen.

  10. Stephanie,I know you have long had faith in Abba Lerner's "Functional Finance" perspective about the benefits of public sector debt when the economy is not fully maximizing its resources.Would you agree with me that if you reduce the national debt via higher taxation, you will also lower property values, lower stock prices, and reduce many other forms of wealth, and you might also accelerate deflationary forces (if not offset by heterodox monetary policy)?I imagine you might agree with me about this.But consider further: The destruction of private sector wealth will also lead to a "Pigou-effect" causing increased desire to rebuild it.This Pigou-effect will stimulate investment, animal spirits, and entrepreneurialism. The capital formation will help close the output gap and rejuvanate the economy. As the debt is reduced the economy will regain its historic levels of growth. This is the stuff that ends Lost Decades of economic stagnation, like the kind that has prevailed in Japan for the 20 years that I have lived here.Of course rejuvanation won't happen overnight. Wealth destruction is not immediately good for employment. But removing some of the burden of the deadweight public debt is the surest way to awaken the dormant growth forces in the economy. But don't take my word on this. Back in 1949 Nobelist James Meade challenged the basic assumptions of Functional Finance (and modern-day MMT) in his seminal article "Is The National Debt a Burden?".I would be very curious to hear your thoughts about his article.http://www.cui-zy.cn/Recommended/Liberalsocialism/MeadeDebtBurden.pdfsincerely,Nick RKyoto, Japan

  11. If you tax someone with low propensity to spend and redistribute that same $ of tax revenue to someone with a higher propensity to spend, then, to my logic, government could increase GDP without running deficits. The propensity to spend does not have to be negative – there just needs to be a delta between one group and another to make use of. Btw., the link to Mosler's site does not link to any specific article.

  12. Another excellent post. One thing I'm confused about is I thought the Fed just recently released a report (which PragCap noted) that said the money multiplier is a myth. John1025

  13. It is not impossible for the US government to achieve this "dream" without increasing its fiscal stance. For example .. The whole private sector suddenly has higher animal spirits and goes on a spending spree by higher credit creation. Its a bit less likely, given the private sector is repairing its balance sheet, but has an epsilon chance nonetheless. The same happened in the late 90s and early 2000s .. the high demand created without the US government having relaxed its fiscal stance .. in fact the government had a tight fiscal stance. The same can happen if the US current of balance of payments improves due to drastic improvement in exports. Of course, this doesn't mean that the US government shouldn't do anything .. but there are possibilities but chances are extremely low.

  14. Do corporate assets held offshore count as foreign sector or domestic sector? How do you know what is held offshore and when it is moved back to the states?

  15. Anon June 18, 2011 9:00 AM Quote: money multiplier is a myth. Different Money multiplier — this is the "Bank Money Multiplier" and the myth being "Banks use the money on deposit to make loans, multiplying the money on deposit" — Banks still create large amounts of money as they loan — but the myth part is that they do not need any bank deposits to do so.

  16. Stephanie;Thanks for another fine article. I'm glad you include just enough algebra to make it feel a little like work. But regarding the president and the Democrats, I'm not sure why we bother. The dominant corporatist faction of the Democratic Party is at least as clueless as most Republicans – and just as hypnotized by the Debt-zilla monster they have created in their heads. I'm hoping to see topics that will make sense to the state legislators and state senators who are on the front lines of the fight against right-wing Governors like Scott Walker and John Kasich. Barack Obama's idea of what to do about Kasich is to invite him to play golf.

  17. Stephanie,There is a way for the President to get rid of the deficits in one stroke without any of the problems you lay out. Since we know that Debt ceiling, and funding the government through debt is an artifact of the old gold standard days, there is another law from those very days that is on the books, that can be used by the secretary of the treasury — that is the power of coin seigniorage.The idea has been laid out by Beowulf, and Joe Firestone, and has been discussed here, at Daily Kos among other places.Quote:It also includes the authority for the Executive to employ jumbo coin seigniorage to replenish the Treasury General Account at the Fed and pay all of the obligations of the United States without issuing more debt or even, technically, any more “deficit spending.” As beowulf puts it: The Secretary has rather broad authority to mint coins, Congress was apparently feeling generous when it authorized platinum coins in 31 USC 5112(k) (“with such specifications, designs, varieties, quantities, denominations, and inscriptions and inscriptions as the Secretary, in the Secretary’s discretion, may prescribe…”). If deficit spending was paid for (eliminated actually) with miscellaneous receipts revenue generated by selling the Fed jumbo denomination coins, and since the Federal Fund Rate can now be pegged with Interest on Reserve payments in lieu selling Treasuries to drain excess reserves, Tsy could fund govt operations indefinitely without ever raising the statutory debt limit.Beowulf might also have pointed out that national debt can eventually reduced to near zero with the constant use of coin seigniorage. Details of how coin seigniorage would work with citations to legal issues involved are in beowulf's post; and an outline of steps in a procedure is in my recent post.7) o, since the Executive has a way of paying all obligations without deficit spending by using coin seigniorage and its Constitutional duty is to uphold both the Constitution and the laws of the United States, it follows that the Executive must immediately end its violation of the law, and use coin seigniorage to replenish the TGA as necessary to implement all the spending appropriations passed by Congress and all the previous obligations of the United States. It is time for the democrats to use a law that serves their agenda, and trump an agenda and law that threatens to throw us back into the stone age.

  18. What about the impact to GDP from changes in exchange rates when governments run large deficits (and particularly deficit spending that does not produce sustained GDP growth)? I believe the recent dollar weakness is in part a function of the forex market expecting too many dollars chasing imported good and/or expectations that GDP return from deficit spending is underwhelming. So an increase in tax or decrease in the deficit can create a stronger USD that hurt exports but make the imports (oil, food and walmart items) cheaper. Even though we are primarily a consumption based economy, I'm not sure if say a 10% currency appreciation would lower gas prices by 10% and if that extra disposable income would be GDP incremental beyond the loss you show above.That said, a decrease in tax or increase in the deficit (as we had in the past few years) weaken the dollar boosting our exports and increasing the price of our imports (oil, food etc). Again does a 10% currency depreciation, increase food/gas prices by 10% and bite into most of the consumers disposable income which hurts the economy even more?The other factor is how the weak USD increases the price of commodities and the global impact that has the wellbeing of citizens of emerging markets being that it is the world's reserve currency. Now if the USD is weakening more than emerging currencies that would be plus (though commodities speculation worsens the situation).At any rate, I'm for any deficit spending or tax changes that lowers our debt interest/GDP ratio in the long run. And not from a fear of solvency, but the importance of a stable reserve currency (absent of excessive money supply printing).

  19. they just keep complicating things, when they should be simplifying…too many politicians, that's the problem

  20. Since MPC is effectively 0 for those with incomes over $1M, we can eliminate the deficit with a steep progressive income tax (e.g., 50% on amounts over $1M, 65% on amounts over $10M, 80% on amounts over $50MM, 95% on amounts over $100MM) and create government jobs at 50K – 100K, where the MPC is high. Raise taxes and increase employment. The mathematics shouldn't be too difficult, just a little linear algebra: Y = [y1, y2, y3, …]; MPC = [mpc1, mpc2, mpc3 …]

  21. Clonal, coin seignorage is a way of avoiding interest-bearing debt -"printing bonds" – relevant because of peculiarities of US law. "Printing money" (currency), either directly or through the modern antics called QE – issue bonds & then buy them back – is economically the same thing. What the government calls it spending and whether the Treasury and the Fed owe each other a quadrillion dollars or not is meaningless. Neither way avoids deficits, which are the difference between spending and taxation, interactions with the real, nongovernment economy.

  22. It is not necessary for the marginal propensity to spend to be negative to make tax increases on the rich reduce the deficit. It is only necessary for the relative propensity to be lower for those taxed than for those employed by spending financed by that tax.If spending is constrained by a deficit cap, tax increases on the rich could serve as funding for new spending, which would employ the working class with a higher propensity to spend. There is no increase in the deficit. There is increased output and employment.There is the fact that in eras with higher tax rates on the rich, output was greater and deficits were lower. There is also the obvious fact that as far as a dollar of spending is concerned, it doesn't care whether it comes from taxing the rich or borrowing from the rich. And there is the political fact that a great number of otherwise intelligent people do not like deficits, but don't mind taxing the rich. (Bonus fact: nations with high marginal tax rates on the rich have no worse economic outcomes, and often much better, than the U.S.)

  23. Calgacus,of course what you say is true. However, that is not the game being played in DC.MMT clearly shows that the old definition of deficit are meaningless in a fiat currency world. What matters is "Where does the government spend?" "Who does the spending benefit?" "Who and where does the government tax" "Who benefits from this taxation" Also important is the question "Is the economy at full resource utilization?" If this is the case, either spending has to reduce, or taxation has to increase. I believe that the taxation policy would be the answer there, as appropriate taxation policy can result in "automatic stabilization"This can be currently seen in the Indian economy where India: Tax Revenues SurgeQuote:According to the final data released by the Government and quoted in the Economics Times, "Overall gross direct tax collections in the April-June quarter are up 45% compared to the year-earlier." This is a much larger growth in tax revenues than had been expected from preliminary reports on corporate tax receipts. Based on preliminary news agency releases, GEI News reported three days ago that first quarter advance tax payments from India's top 100 companies were up by 14%. …The growth in tax revenues far oustripped the growth in the two preceeding quarters (30% and 19%).

  24. "If you think you can cut the deficit without destroying jobs, dream on."Cutting the deficit/increasing the surplus means either the amount of medium of exchange falls (if you believe the gov't destroys it) or its velocity falls (if you believe the gov't saves it).If lower interest rates increase the amount of medium of exchange or increase its velocity, then cutting the deficit/increasing the surplus could be counteracted. Increasing net exports could counteract it also. IMO, both of those assume supply constraints somewhere.The other possibility is to increase the amount of medium of exchange with no bond/loan attached.

  25. "So instead of continuing to put the deficit first, it’s time get to work on a plan to increase employment."What about a plan to increase retirement?

  26. [Calgacus] point taken

  27. Contrary to the suggestion in the last sentence of the above article, the deficit can quite easily be cut without destroying jobs. See here:http://ralphanomics.blogspot.com/2011/06/fast-fiscal-consolidation-would-not.html

  28. Stephanie, this is an excellent article, and I wanted to share it today, but the images in the article seem to be missing ?