Monthly Archives: June 2009

Government Deficits Generate Household Savings

by L. Randall Wray

A Bloomberg report by Rich Miller and Alison Sider recently noted that “Americans are shutting their wallets and building their nest eggs at the fastest pace in 15 years.” It went on: [T]he household savings rate rose to 6.9 percent in May, the highest since December 1993, as personal spending increased less than incomes. The rate in April 2008 was zero. Most of the rise in income in May was due to one-time government stimulus payments to seniors, said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington, Massachusetts.
These should not be surprising events, as we have explained in previous posts (here, here and here). Government sector spending creates private sector income; government sector deficits create private sector savings. These are identities that virtually no one recognizes. I can recall that during the Clinton administration’s budget surpluses, the Wall Street Journal ran two front-page stories side-by-side, one congratulating the government for finally getting its budget in order—supposedly adding to national savings–and the other chastising consumers for spending more than their incomes—reducing national savings. The rising Obama budget deficit will help our private sector to accumulate savings and retire debt, part of the necessary remedy to the run-up of debt that occurred over the past dozen years. Unfortunately, fiscal policy remains too tight, as evidenced by continued (and, I think, growing) stress in the retail sector.

The report goes on: “the trend will put the country’s finances in better balance and reduce its dependence on Chinese investment”. Now this is utterly confused. Yes, our household sector’s finances will improve and might eventually recover—if the fiscal stance loosens and job losses are turned around to employment growth. However, the US did not, indeed in a significant sense cannot, rely on the Chinese. Our spending is in dollars, and we are the source of those dollars. Needless to say, every dollar spent by the Chinese was generated by us. In fact, we “financed” their accumulation of dollars, mostly through our current account deficit (we bought more stuff from them than they bought from us). This allowed them to “net save” in dollar assets. As our trade deficit with China shrinks (by the way, not necessarily a good thing for us!), China’s net saving in dollars will also shrink. It is quite unlikely that the trade balance will reverse any time soon (China is not going to become a net importer in the near future), so China will continue to accumulate dollar assets although (probably) at a reduced pace. But that does not “finance” US domestic spending.

Why The Stimulus Isn’t Working

by Stephanie Kelton

President Obama’s economic advisors are predicting that the recession will come to an end sometime this year, as fiscal stimulus spending kicks into high gear. But the conditions for an economic recovery have not been laid.

What the left hand giveth (see table), the right is quickly taking away.

And I’m not talking about the “right-wing.” I’m talking about state and local governments across the nation, who are unwittingly pulling the rug out from under the federal government and thwarting any chance for a sustainable recovery by 2010.

But it isn’t their fault. Tax revenues have fallen off a cliff, leaving states with a cumulative budget gap of more than $100 billion for fiscal ’09.

To deal with these shortfalls, states have laid off or furloughed thousands of employees, raised taxes and fees, and slashed spending on education and other social programs – some, many times over. It was supposed to balance their ’09 budgets. But it wasn’t nearly enough.

As it turns out, state officials were far too optimistic about the ’09 revenue picture, and they are scrambling to deal with widening shortfalls before the end of the fiscal year (which, by the way, is tomorrow for all but a few states). At this stage in the game, there are only a couple of ways for states to balance their ’09 budgets (it’s too late for more tax hikes and spending cuts). Most are expected to do one of two things: (1) tap rainy day funds or (2) use federal stimulus money.

For example, Ohio is expected to dip into its $948 million rainy day fund in order to deal with its worst-ever decline in tax revenue. Meanwhile, Massachusetts Gov. Deval Patrick has indicated that his state will be forced to use some of its federal stimulus money to plug a budget gap of nearly $1 billion by June 30.

The problem, of course, is that the macroeconomic effects of these micro-level policies are working at odds against the federal stimulus effort. Jobs that are being created (or saved) through the left hand of the Obama stimulus package are disappearing at least as rapidly as the right hand slashes billions from state budgets.

And, while Obama’s advisors are focused on the silver lining in the recent job data (losses are slowing), the employment picture remains bleak. The following table shows the change in unemployment rates – by state – since the start of the recession and from April ’09 to May ’09.

All but two states saw an increase in unemployment last month, and fourteen states are now in double-digit territory. President Obama’s economic team has admited that the national average will probably reach double-digits, but they anticipate a turnaround as a flood of stimulus money makes its way into the economy later this year.

But Obama’s advisors may be overlooking the fact that much of the stimulus money isn’t going to be there to fund new projects and drive economic growth. This is because states like Massachusetts are diverting stimulus money away from future projects in order to cover past (2009) budget shortfalls.

And the worst may be yet to come. States are bracing for even bigger revenue shortages next year, and governors across the nation are warning of deeper cuts in fiscal 2010. And right now, no single state poses a bigger threat to the nation’s economic recovery than California.

With an estimated $24 billion budget shortfall and a July 1 deadline to close its deficit, California’s top officials asked the federal government for emergency funding to help alleviate further drastic cuts in state spending. But the president’s top economic advisors – including Treasury Secretary Timothy Geithner, and White House economists Lawrence Summers and Christina Romer – rejected Gov. Schwarzenegger’s request for aid, choosing, instead, to admonish the governor for failing to put California’s fiscal house in order.

The Washington Post reported that Gov. Schwarzenegger was denied federal assistance because White House officials feared that it would lead to “a cascade of demands from other states.” This kind of head-in-the-sand thinking will have tragic consequences.

States need more aid, and they need it now. The White House should be faced with a cascade of demands, and these demands should come from a broad coalition of governors, who storm the White House – cameras rolling – to explain the dire consequences of denying them emergency aid. Randy Wray suggested, in a previous post, that states need another $400 billion or so, and that seems like a reasonable figure. I would urge our nation’s governors to immediately request an additional $1,000 per resident.

As I have argued in a previous post, the Obama administration’s initial forecasts were far too rosy, and the Economic Recovery & Reinvestment Act didn’t provide enough aid for states. More needs to be done, and it needs to be done now. Every dollar slashed from a state budget undermines a dollar of federal stimulus spending.

The Congressional Budget Office’s long-term budget outlook

by Felipe Rezende and Stephanie Kelton

The Congressional Budget Office (CBO) has just released its long-term budget outlook. The dismal report warns:

“Although great uncertainty surrounds long-term fiscal projections, rising costs for health care and the aging of the U.S. population will cause federal spending to increase rapidly under any plausible scenario.” Given these large increases in projected spending, the report went on to caution that “[u]nless tax revenues increase just as rapidly, the rise in spending will produce growing budget deficits and accumulating debt.” Finally, the report asserts that the ensuing “[l]arge budget deficits would reduce national saving, leading to more borrowing from abroad and less domestic investment, which in turn would depress income growth in the United States.”
Once again, we find it necessary to point out the flawed logic of those who certainly ought to have a better understanding of things. First, taxes do not pay for government spending. It would help a great deal if those at the CBO (and elsewhere) would work through the balance sheet entries to decipher exactly how government “financing” operations work.

As Kelton and Wray have explained in earlier posts, the federal government spends by crediting bank accounts. Period. Tax payments to the government result in the destruction of money — high-powered money to be exact — as the banking system clears the checks and reserve accounts are debited. In other words, taxes don’t provide the government with “money to spend”. Tax payments destroy money. Not in theory. Not by assumption. By definition.

Second, growing budget deficits do not reduce national savings. They do just the opposite. Indeed, the private sector — households and firms taken as a whole — cannot attain a surplus position unless some other sector (the public sector or the foreign sector) takes the opposite position. Again, it is an indisputable feature of balance sheet accounting that is governed by the following identity:

Private Sector Surplus = Public Sector Deficit + Current Account Surplus

This fundamental accounting identity can be found in any decent International Economics texbook (see, e.g., Krugman and Obstfeld), and it is one of the most important macroeconomic concepts we can think of. It demonstrates the conditions under which national savings will be positive. Not in theory. Not by assumption. By definition.

Source: Levy Institute

To appreciate the interplay, consider the main sector balances in 2004. The public sector’s deficit of about 5% of GDP was just enough to offset the 5% current account deficit, leaving the private sector with no addition to its net saving (i.e. private sector savings were zero). Today, in contrast, private savings are up sharply because: (1) the public deficit is up sharply and (2) the external deficit is declining. Add today’s (rising) public deficit to today’s (falling) current account deficit and, voila, the CBO’s much-feared explosion in the government deficit has translated into an explosion in private savings.

As for the relationship between savings and investment . . . let’s tackle that accounting lesson next week.

Update: See some Wynne Godley’s pieces here, here , and here. See also Krugman’s piece here.

The Financial Instability Hypothesis

Janet Yellen, President of the San Francisco Federal Reserve, pointed out at the 18th annual conference honoring the work of Hyman P. Minsky that:
“… with the financial world in turmoil, Minsky’s work has become required reading. It is getting the recognition it richly deserves.”

Paul Krugman has also been re-reading Hyman Minsky’s most famous book Stabilizing an Unstable Economy.

Central to Minsky’s view of how financial meltdowns occur is his Financial Instability Hypothesis (FIH) — what has come to be known as ‘an investment theory of the business cycle and a financial theory of investment’. But, what is it all about? Quoting from Minsky . . .

“The theoretical argument of the financial instability hypothesis starts from the characterization of the economy as a capitalist economy with expensive capital assets and a complex, sophisticated financial system… The focus is on an accumulating capitalist economy that moves through real calendar time…”

“The capital development of a capitalist economy is accompanied by exchanges of present money for future money. The present money pays for resources that go into the production of investment output, whereas the future money is the “profits” which will accrue to the capital asset owning firms (as the capital assets are used in production). As a result of the process by which investment is financed, the control over items in the capital stock by producing units is financed by liabilities–these are commitments to pay money at dates specified or as conditions arise. For each economic unit, the liabilities on its balance sheet determine a time series of prior payment commitments, even as the assets generate a time series of conjectured cash receipts…
A part of the financing of the economy can be structured as dated payment commitments in which banks are the central player…”

“Thus, in a capitalist economy the past, the present, and the future are linked not only by capital assets and labor force characteristics but also by financial relations. The key financial relationships link the creation and the ownership of capital assets to the structure of financial relations and changes in this structure…”

“In spite of the greater complexity of financial relations, the key determinant of system behavior remains the level of profits. The financial instability hypothesis incorporates the Kalecki (1965)-Levy (1983) view of profits, in which the structure of aggregate demand determines profits. In the skeletal model, with highly simplified consumption behavior by receivers of profit incomes and wages, in each period aggregate profits equal aggregate investment…”

“In a more complex (though still highly abstract) structure, aggregate profits equal aggregate investment plus the government deficit. Expectations of profits depend upon investment in the future, and realized profits are determined by investment: thus, whether or not liabilities are validated depends upon investment. Investment takes place now because businessmen and their bankers expect investment to take place in the future…”

“The financial instability hypothesis, therefore, is a theory of the impact of debt on system behavior and also incorporates the manner in which debt is validated….”

“The financial instability hypothesis takes banking seriously as a profit-seeking activity. Banks seek profits by financing activity and bankers. Like all entrepreneurs in a capitalist economy, bankers are aware that innovation assures profits. Thus, bankers (using the term generically for all intermediaries in finance), whether they be brokers or dealers, are merchants of debt who strive to innovate in the assets they acquire and the liabilities they market…”

“Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified.
Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows.
Speculative finance units are units that can meet their payment commitments on “income account” on their liabilities, even as they cannot repay the principle out of income cash flows. Such units need to “roll over” their liabilities: (e.g. issue new debt to meet commitments on maturing debt)
For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts.”
“Over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.
In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.”
“Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.”
“The financial instability hypothesis is a model of a capitalist economy which does not rely upon exogenous shocks to generate business cycles of varying severity. The hypothesis holds that business cycles of history are compounded out of (i) the internal dynamics of capitalist economies, and (ii) the system of interventions and regulations that are designed to keep the economy operating within reasonable bounds.”

Source: Excerpts from Hyman Minsky’s 1992 paper linked to above.

Update: A good summary of Minsky’s view can be found here and here.

“William Black: Obama’s Regulation Proposal “Too Timid””

The Fiscal Storm

By L. Randall Wray

While most commentary about government budgets has centered on the federal government, the real concern is the impact of the economic crisis on state and local government budgets. Unlike the federal government, state and local governments really do need tax revenue to finance their spending. As the economy has slowed, tax revenues have plummeted for these governments. All US states but one have constitutional requirements that dictate balanced budgets. However, even if this were not the case, states try to submit balanced budgets because markets punish deficits by credit downgrades and interest rate hikes. Hence, an economic slowdown forces states to tighten. The following graphics from today’s New York Times are telling:

Since the Nixon era, Keynesian economic policy had fallen out of favor. Not only were “welfare” programs cut, but federal government also reduced its support for state governments through devolution (moving program responsibility to the state and local government level), it slowed growth of spending—especially on defense–and it increased payroll taxes, which reduced the role of the federal government while gradually tightening the fiscal stance. This finally led, over the course of the 1990s Goldilocks expansion, to sustained and large fiscal surpluses. In spite of the conventional wisdom, fiscal policy remained chronically too tight—and is probably still too tight but that is a topic beyond the scope of this blog.

Turning to the state level, states were faced with more responsibility, especially for social programs like welfare and Medicaid. However, all but one state is restricted by statutes or constitutions to running balanced budgets. The problem is that state revenue is strongly pro-cyclical, increasing in a boom and falling in recession. And this is a big problem when the states are increasingly responsible for types of spending that need to rise in recession—like welfare and Medicaid. What States typically do is to cut taxes and increase spending in a boom—which helps to fuel the boom—and then raise taxes and cut spending in a recession—adding to the depressionary forces that generate the recession. States have also come to rely more heavily on regressive taxes—especially taxes on consumption, while like the Federal government they give tax credits and inducements to encourage saving. This depresses spending, especially in recession when the regressive taxes on consumption are increased at exactly the time that households are trying to cut back spending to increase rainy day funds.

In addition to the current revenue problems faced by states, the second challenge, only dimly recognized, lies in the very real needs neglected by the federal government since the days of President Nixon: public infrastructure investment, public health services, pre-collegiate education, training and apprenticeships programs for those who will not attend college, jobs programs for those not needed in the private sector, and fiscal relief for state and local governments. So what we need now is a major federal government program comprised of three parts: immediate fiscal relief for state and local governments, longer term revenue substitution, and national infrastructure funding.

1. Immediate relief: To do immediate good, we need to ramp up federal social spending to relieve state budgets. Increased unemployment compensation and other forms of social spending are needed. It is also important to help state and local governments, which are reeling from the double whammy of higher expenses and plummeting tax revenues. They need at least $400 billion of “block grants”—perhaps based on population—to be spread among these governments. Maybe some of the money would be targeted (public infrastructure projects that were already underway, or are on the shelf and ready to go), some would go to Medicaid, and some would come with no strings attached.

2. Reducing use of regressive taxes: The “devolution” that has taken place since the early 1970s puts more responsibility on state and local governments but without funding it; in response they have increased (mostly) regressive taxes such as sales and excise taxes. So in addition to immediate relief, we also need to encourage them to move away from regressive taxes (in the average state, poor people pay twice as much of their income in state and local taxes as do the rich). I suggest we offer federal government funding to states that agree to eliminate regressive taxes (except for the taxes on sin), on dollar-for-dollar basis. Of course, there are some fairness issues involved (states that relied more on regressive taxes would get more relief), so, again, federal tax relief could be determined on a per capita basis, with each state required to eliminate its most regressive taxes.

3. Public Infrastructure: Elsewhere, I have argued that government spending needs to operate like a ratchet: increase in bad times to get us out of recessions, and increase in good times to generate demand for growth of capacity. What should we spend on? Infrastructure, social programs and jobs. Here I will just focus on infrastructure spending. We’ve got a $2 trillion public infrastructure deficit—just to bring America up to the minimal standard expected by today’s civil engineers. If anything, our relative dearth of public investment in roads, parks, schools, and energy infrastructure is even worse than it was when J.K. Galbraith brought it to our attention. The long fashionable belief that the market knows best now seems crazily improbable. Heck, the market couldn’t even do a relatively simple thing such as determine whether someone with no income, no job, and no assets ought to be buying a half million dollar McMansion with a loan to value ratio of 120%. Jimmy Stewart’s heavily regulated thrifts successfully financed more housing with virtually no defaults or insolvencies, and with none of the modern rocket scientist models that generated the subprime fiasco. Let the market mow lawns and determine toothpaste flavors; leave the important stuff—education, child and elder care, health care, military and security services, interstate highways and other social infrastructure and services–to government.

The Global Reserve Currency

From the Financial Times by Michael Hudson:

“For starters, the six countries intend to trade in their own currencies so as to get the benefit of mutual credit, rather than give it to the US. In recent months China has struck bilateral deals with Brazil and Malaysia to trade in renminbi rather than the dollar, sterling or euros.

Many foreigners see the US as a lawless nation. How else to characterise a country that holds out a set of laws for others – on war, debt repayment and the treatment of prisoners – but ignores them itself?

The US is the world’s largest debtor, yet has avoided the pain of “structural adjustments” imposed on other debtor nations. US interest rate and tax reductions in the face of exploding trade and budget deficits are seen as the height of hypocrisy in view of the austerity programmes that the “Washington consensus” has forced on other countries via the International Monetary Fund and other vehicles. The US tells debtor economies to sell off their public utilities and natural resources, raise their interest rates and increase taxes while gutting their social safety nets to squeeze out money to pay creditors.”

Professor L. Randall Wray responds to a question:

Question: I heard a news report that the US Government is issuing bonds to finance its budget deficit, and that this will drive up interest rates and might even threaten government solvency. Also I have heard that the US Government has to rely on China to finance our deficit. Isn’t that why the stock and bond markets are bearish?

Answer: This news report reflects two related misunderstandings: first, that government “funds” its deficit by borrowing; second that a large deficit threatens government with insolvency. Let me first deal with those fallacies, then move on to what is happening in markets.

Government spends by crediting bank accounts (bank deposits go up, and their reserves are credited by the Fed). All else equal, this generates excess reserves that are offered in the overnight interbank lending market (fed funds in the US) putting downward pressure on overnight rates. Let me repeat that: government spending pushes interest rates down. When they fall below the target, the Fed sells bonds to drain the excess reserves—pushing the overnight rate back to the target. Continuous budget deficits lead to continuous open market sales, causing the NY Fed to call on the Treasury to soak up reserves through new issues of bonds. The purpose of bond sales by the Fed or Treasury is to substitute interest-earning bonds for undesired reserves—to allow the Fed to hit its interest rate target. (In the old days, these reserves earned no interest; Chairman Bernanke has changed that, effectively eliminating the difference between very short-term Treasuries and bank reserves. It also entirely eliminates the need to issue Treasuries—but that is a topic for another day.) We conclude: government deficits do not exert upward pressure on interest rates—quite the contrary, they put downward pressure that is relieved through bond sales.

On to the question of insolvency. Let me state the conclusion first: a sovereign government that issues its own floating rate currency can never become insolvent in its own currency. (While such a currency is often called “fiat”, that is somewhat misleading for reasons I won’t discuss here—I prefer the term “sovereign currency”.) The US Treasury can always make all payments as they come due—whether it is for spending on goods and services, for social spending, or to meet interest payments on its debt. While analogies to household budgets are often made, these are completely erroneous. I do not know any households that can issue Treasury coins or Federal Reserve Notes (I suppose some try occasionally, but that is dangerously illegal counterfeiting). To be sure, government does not really spend by direct issues of coined nickels. Rather, it spends by crediting bank accounts. It taxes by debiting them. When its credits to bank accounts exceeds its debits to them, we call that a budget deficit. The accounting and operating procedures adopted by the Treasury, the Fed, special deposit banks, and regular banks are complex, but they do not change the principle: government spending is accomplished by crediting bank accounts. Government spending can be too big (beyond full employment), it can misdirect resources, and it can be wasteful or undesirable, but it cannot lead to insolvency.

Constraining government spending by imposing budgets is certainly desirable. We want to know in advance what the government is planning to do, and we want to hold it accountable; a budget is one lever of control. At this point, it is impossible to know how much additional government spending will be required to get us out of this deep recession. Whether the Obama team finally settles on $850 billion worth of useful projects, or $1.5 trillion, voters have the right to expect that the spending is well-planned and that the projects are well-executed. But the budgets ought to be set with regard to results desired and competencies to execute plans—not out of some pre-conceived notion of what is “affordable”. Our federal government can afford anything that is for sale in terms of its own currency. The trick is to ensure that it spends enough to produce sustainable growth and other desired outcomes while at the same time ensuring that its spending does not have undesirable outcomes such as fueling inflation or taking away resources that could be put to better use by the private sector.

Why do stock markets and bond markets react the way they do, given that insolvency is out of the question? Sophisticated market players do recognize that government cannot go insolvent and that government will always make all interest payments as they come due. Markets are, however, concerned that all the government spending plus the Fed bail-outs (lending reserves and buying bad assets) will be inflationary. In the current environment, that is quite unlikely. Even if oil prices stabilize at a higher level, that will not compensate for all the deflationary pressures around the world as firms cut prices to maintain sales in the face of plummeting demand. Still, it is not really inflation that bond markets are worried about, but rather future Fed interest rate hikes. (Again, that will not happen in the near future, and might not happen for several years—but there is little doubt that the Fed will eventually raise rates when the economy finally recovers.) Rate hikes lead to capital losses on longer-maturity bonds (interest rates and bond prices always move in the opposite direction). The Treasury persists in issuing bonds with a range of maturities (although the maturity structure in recent years has shortened). This is evidence that the Treasury does not fully understand the purpose of bond sales (since bonds are simply an alternative to bank reserves, it makes most sense to offer only overnight bonds)—but, again, that is a topic for another day.

The Treasury is having some trouble selling the longer maturity bonds (so their price is low and their interest rate is high). China is probably playing a role in this because they are shunning longer maturity debt out of fear of capital losses; they have also shifted some of their portfolio to other currencies (partly to diversify so that they will not lose if the dollar depreciates, and perhaps to pressure US authorities to keep the dollar strong). The solution is that the Treasury should shift even more strongly to shorter maturities—something it will do even if it does not fully understand why it should: Treasury sees that short term interest rates are much lower, hence, will sell short term debt to reduce the “cost of funding the deficit”. If Treasury really understood what it was doing, it would simply offer overnight deposits at the Fed, paying the Fed’s target interest rate. Then it would not “need” to sell bonds at all, and we could stop worrying about government “borrowing from the Chinese”. If the Fed wanted to control interest rates of longer term debt, it can offer interest on deposits of different maturities—for example, it can offer an overnight rate, a 30 day rate, a 90 day rate, and so on, for deposits held at the Fed.

Don’t Fear the Rise in the Fed’s Reserve Balances

By Scott Fullwiler

Many in the financial press have noted the rise since September 2008 in the Fed’s reserve balances from about $20 billion to more than $800 billion today. A number of well-known economists have expressed concern that this will be inflationary.

However, fears that these are inflationary are misplaced, even inapplicable, as they apply only to a monetary system operating under a gold standard, currency board, or similar arrangement, not the flexible exchange rate system of the U. S.

Under a gold standard, for instance, banks must be careful when creating loans that they have sufficient gold or central bank reserves to meet depositor outflows or legal reserve requirements. This is the fractional banking, money multiplier system standard in the economics textbooks. If there is an inflow of gold, then bank deposit creation can increase and prices can rise. The same can occur if the central bank raises the quantity of reserves circulating relative to its own gold reserves.

Continue reading

Will the Run-Up in Government Debt Doom Us All?

By Stephanie Kelton

Arthur Laffer has taken aim at Chairman Bernanke and President Obama, warning that somewhere down the road their policies will exact a huge price on the American economy. With respect to the Chairman’s handling of monetary policy, Mr. Laffer predicts “rapidly rising prices and much, much higher interest rates.” I am not going to critique Laffer on this point, because Paul Krugman and Mark Thoma have already done so in fine form.

Instead, I want to address Mr. Laffer’s fiscal concerns. He said:

“Here we stand more than a year into a grave economic crisis with a projected budget deficit of 13% of GDP. . . With U.S. GDP and federal tax receipts at about $14 trillion and $2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and partial default on government promises.”

I believe that he is wrong on each of the above points, and here is why:

1. Increases in the federal deficit tend to decrease, rather than increase, interest rates. This is because deficit spending leads to a net injection of reserves into the banking system. (And big deficits imply big injections of reserves.) When the banking system is flush with reserves, the price of those reserves – in the U.S. the federal funds rate – is driven to zero (yes, zero!). Unless a zero-bid is consistent with Fed policy, the central bank will begin selling bonds in order to drain excess reserves. The bond sales continue until the fed funds rate falls within the Fed’s target band. The Federal Reserve sets the key interest rate in the U.S., and it can always hit any nominal interest rate it chooses, regardless of the size of the budget deficit (or debt). And this isn’t just true of the Fed. Just look at the Japanese experience:

Thus, despite a debt-to-GDP ratio in excess of 200%, the Bank of Japan never lost the ability to set the key overnight interest rate, which has remained below 1% for about a decade. And, the debt didn’t drive long-term rates higher either. The chart below shows that rates on 10-yr government bonds trended sharply downward as Japan’s public sector debt exploded:

Laffer’s prediction about what will happen to U.S. interest rates as a consequence of the Obama stimulus package are based on a faulty understanding of the relationship between deficit spending, bank reserves and interest rates. The Japanese experience serves as prime example of his flawed logic. (My fellow bloggers, Scott Fullwiler, Randy Wray and I have all published numerous articles that lay out the technical details surrounding the coordination of Treasury Fed operations and the management of U.S. interest rates.)

2. Increases in the federal deficit (and the subsequent run-up in outstanding debt) do not mandate higher taxes in the future. Taxes do not “pay for” the deficits we ran in the past. Taxes drain reserves (an important function) and constrain aggregate demand. Tax revenue obviously moves endogenously, with the business cycle, but revenues can also change as a matter of policy. What Mr. Laffer is apparently arguing is that today’s deficits will require “tomorrow’s” leaders to raise marginal tax rates (or impose new taxes). But this isn’t the U.S. experience.

Corporate taxes, as well as taxes on the wealthiest Americans, have trended downward for decades, even as the U.S. debt quadrupled in size.

And, while payroll taxes have risen steadily over the past 40 years, tax revenues, as a percentage of GDP have hardly budged in more than 50 years.

Thus, Laffer’s assertion that the current run-up in government debt will require “massive tax increases” isn’t borne out by our experience. And, it wasn’t the case in Japan either:

Despite an explosive increase in the government debt in both the U.S. (throughout the 1980s and again under George W. Bush) and Japan (especially in the late 1990s and early 2000s), taxes in both countries are among the lowest in the developed world.

3. Laffer contends that a “partial default on government promises” is an inevitable consequence of the Obama administration’s “ill-conceived” fiscal policies. A statement like this is at best misleading and at worst intellectually dishonest.

As any serious macro economist knows, a government like the United States – i.e. one that controls its own currency – can meet any and all outstanding financial obligations, provided the debts are denominated in the national currency. This is a point that Alan Greenspan made several years ago, when he wrote that “the U.S. government, by virtue of its ability to create money, can never become insolvent with respect to obligations in its own currency.”