Letter to a Seventh Grader (and also to the Director of the Congressional Budget Office)

By Randall Wray and Yeva Nersisyan

A few of days ago a Letter to a Seventh Grader written by the Director of the Congressional Budget Office appeared on the CBO’s blog. It is nice to have a responsive public official. Unfortunately, the CBO’s Director does not understand federal budgeting. He seems to believe the US still operates on a gold standard. At best, his letter should be taken as a history of thought lesson, something that a CBO Director might have written to a seventh grader in 1931. There is nothing in the letter that would help anyone to understand government finance in the US today, in the post-Bretton Woods era with a floating exchange rate, non-convertible—sovereign – currency.

So we have decided to correct the CBO’s errors and to provide a letter to a seventh grader that actually addresses the current situation. Here are the questions of the 7th grader, the CBO Director’s responses (in italics) and, then, our (correct) response to the questions.

1. What are the primary causes of the current federal budget deficits?

The current large deficits are the result of a combination of factors. These include an imbalance between tax revenues and the government’s spending that began before the recent economic recession and turmoil in the financial markets, sharply lower revenues and higher spending related to current economic conditions, and the budgetary costs of policies put in place by the government to respond to those conditions.

The government’s budget is an accounting record of the government’s spending and revenues (mostly taxes). When spending exceeds revenues, the budget is in deficit. To a large degree, the government’s budget balance is non-discretionary and simply mirrors what is going on in the rest of the economy. During a recession private sector spending falls and unemployment rises. As the private sector spends less, the government automatically spends more—especially on unemployment benefits and other forms of social assistance. But most importantly, as economic activity declines, tax revenues fall. Falling tax revenues combined with rising social spending – called automatic stabilizers- create a gap between revenues and expenses resulting in a budget deficit. Economic recovery will automatically reduce the government’s deficit. If growth were so robust as to produce a government surplus, this would mean that the nongovernment sector would be running a deficit. By accounting identity, the sum of the government’s balance plus the non-government’s balance is zero. In other words, today’s government budget deficit is equal to the nongovernment sector’s surplus (also called net financial saving).

2. How will budget deficits affect people under the age of 18?

The government runs a budget deficit when it spends more on its programs and activities than it collects in taxes and other revenues. The government needs to borrow to make up the difference. When the federal government borrows large amounts of money, it pushes interest rates higher, and people and businesses generally need to pay more to borrow money for themselves. As a result, they invest less in factories, office buildings, and equipment, and people in the future—including your generation—will have less income than they otherwise would.

Also, the government needs to pay interest on the money it borrows, which means there will be less money available for other things that the government will spend money on in the future. Squeezing other spending affects different people in different ways, depending on their individual situations. For example, many young people benefit from government programs that provide money to families in need of food or medical care or to people who have lost their job, or from the financial support the federal government provides to local schools, or from the grants or loans the government offers to help pay for college education.

The Federal government (Federal Reserve and the Treasury) is the monopoly issuer of U.S. dollars. The dollars that we all use come from the federal government. This means that the government never has or doesn’t have dollars, nor can it run out of dollars. It just creates them at will whenever it needs to spend.

When the government uses its currency issuing capacity in a meaningful way it can do a lot of good for the private sector. It can hire people who are currently unemployed to build bridges, highways, repair the streets, to care for the elderly and so on. It can provide healthcare to people who need it. It can provide education to those who want to get one. Federal budget deficits create a surplus for the nongovernment sector and federal budget debt is a financial asset and net financial wealth for the nongovernment sector. So budget deficits today mean more income, more roads, schools and hospitals (tangible assets), healthier and more highly educated population and more financial assets for the private sector than it would otherwise have.

Today’s young people look forward to jobs, growing labor productivity and higher living standards in the future. The government has an important role to play to ensure that outcome. By itself, a government deficit is neither good nor bad. What really matters is the consequence: if a budget deficit is too small (spending is too low and/or taxes are too high), then the economy operates below capacity and grows too slowly; if the budget deficit is too large then inflation can result as the government takes too many resources away from private use and prices and wages are bid up. A deficit of the proper size allows the economy to operate at full employment of its resources.

3. How is the U.S. government working to reduce budget deficits?

The President created a National Commission on Fiscal Responsibility and Reform to draw up plans to address the deficit problem. Most of the people on the commission are Members of Congress.The commission will consider ways to reduce the budget deficit by 2015 as well as ways to improve the long-term budget outlook. Under current government policies, the gap between the government’s spending and revenues in coming years will be large. Therefore, balancing the budget would require significant changes in spending, taxes, or both. On CBO’s Web site, you can find information about the budget outlook during the next 10 years and over the long term.

More information about the commission can be found on its Web site: Fiscal Commission

Congress also has enacted a new law (called “Pay-As-You-Go”) that typically requires legislation that increases spending or lowers tax revenues to include other measures to offset the costs of those changes.

Targeting deficit reduction is not an appropriate goal for the federal government. Rather, the budget should be the tool used to achieve the public purpose – better education, infrastructure, healthcare – anything that the public decides it wants/needs. At the macro level, if the government reduces its deficits, the nongovernment sector will have less income and less saving. The National Commission on Fiscal Responsibility and Reform created by the President is misguided because it is trying to reduce the budget deficit in a time of massive quantities of unused and underutilized resources. Those on the Commission don’t understand how our modern monetary regime works and if we followed their advice we would probably cause a “double dip” as the economy fell back into deep recession. Note also that their deficit-cutting proposals most likely would not reduce deficits in any case because a slowing economy sets off the automatic stabilizers—tax revenue would fall and social spending would rise.

4. What can people, and especially school-aged children, do to help curb budget deficits?

The most important thing that school-aged children can do to help reduce future deficits is to study hard and acquire the best possible education. This will help you and your classmates get better jobs when you grow up, which will help the economy grow. In turn, a stronger economy will produce higher tax receipts for the government, which will lower the deficit.When young people get jobs, they should be sure to save some of the money they earn.Through a fun and important bit of math called compounding, savings of small amounts can grow over time into significant amounts. For the economy as a whole, the more people save, the more money is available for businesses to invest in factories, office buildings, and equipment. For individuals and families, more savings provide a financial cushion in times of economic difficulty. In particular, more savings can help people pay large medical expenses or save their home in case they lose their job or become ill, thus helping them avoid needing government assistance.

People of all ages can also help to reduce the deficit by learning how the government spends money and from whom the government collects money. Understanding the current budget is essential for choosing intelligently among different ways to change programs and policies in order to reduce deficits.

Again, cutting the budget deficit is not a legitimate goal—for government or for people. The best thing that a young person can do is to study hard, do well in school, and prepare herself for a long, healthy, and productive life. The best thing for the government to do is to support young people in those pursuits. Unfortunately, those who are trying to reduce the budget deficit will rely mostly on spending cuts that especially hurt young people. Since health, education, and social welfare spending (including Social Security) account for a very large part of government spending (at all levels), those are usually the first programs to be cut by those trying to “balance the budget”. Not only does that mean trouble today, but it has long-term impacts for generations to come. Some projections show that the current generation of school-age children will be the first one that will actually be less educated than their parent’s generation. Rather than cutting back on education, the federal government should be increasing its support for those in school.

5. If I am to convey one key message to my school regarding the federal budget deficit, what would it be?

The prospect of budget deficits for many years in the future is a serious problem for our country. Ultimately, people in the United States will have to bring into balance the amount of services they expect the government to provide, particularly in the form of benefits for older Americans, and the amount of taxes they are willing to send to the government to finance those services. Because it takes a long time to implement major policy changes, deciding what those changes will be is an urgent task for our citizens and for our policymakers.

Do not listen to all the nonsense about the ill effects of budget deficits coming out of Washington. The federal government cannot “run out of money” because it is the issuer of our currency. It can make all payments as they come due. It can never go bankrupt in its own currency. It can afford to spend on the necessary scale to end this recession and to put the economy on track to robust growth. It can afford to create as many jobs as necessary to ensure that anyone who wants to work will be able to make a positive contribution to our economy. It can afford to support programs to protect and restore our natural environment. And it can and must spend more to support our schools.