Keep the Deficit. Ditch the Doves.

By Stephanie Kelton

I just read another disappointing piece dealing with the preliminary recommendations from President Obama’s fiscal commission, this time from a contributor at The Huffington Post. Like any good deficit “dove,” he concedes the existence of the crisis, which he says any idiot with a third-grade education could recognize:

“The magnitude of the financial management of our government does not require algebra, calculus or knowledge of algorithms.”

And while it is true that you do not need differential calculus or linear algebra to understand finance, it does help a great deal if you can read a balance sheet. Unfortunately, this Stanford academic — like so many on the “left” — apparently cannot.What follows is a highly truncated statement that stems from a set of arguments that have appeared many times on this site.  For those who haven’t been following along, it may serve as a primer.

In a ‘closed economy’ (one without foreign trade), the government’s budget position is, by accounting logic — the negative of the private sector’s (firms and households combined) position.  Thus, a public sector DEFICIT is equal to the private sector’s SURPLUS.  To the penny.

Arguments in favor of “fiscal responsibility” miss this fundamental point completely and, in so doing, end up supporting the kinds of policies that will worsen (rather than improve) the private sector’s financial well-being.  Taxes are a “leakage.”  They remove money from the private sector.  Government spending, in contrast, is an “injection.”  It adds money to private sector balances.  When the government spends (injects) more than it taxes (withdraws), the resulting deficit ADDS to the private sector’s holding of net financial assets.  And, should the government run a surplus by collecting (withdrawing) more than it spends (injects), the private sector will end up with FEWER financial assets.  So any deficit, provided it does not push the economy beyond capacity, improves the private sector’s (real) financial position.

The same holds true for an open economy, where imports are a “leakage” and exports an “injection.”  Thus, like a government SURPLUS, a trade DEFICIT reduces the private sector SURPLUS, which creates an even bigger need for a public sector deficit.  As long as we (Americans) continue to run trade deficits, there are only two options:  (1) the government runs deficits (and they must be at least as large as the trade deficit), or (2) the rest of us do.  I know which scenario benefits me.  Do you?

25 responses to “Keep the Deficit. Ditch the Doves.

  1. Aha. There's only one way out of this conundrum. Obama must declare war on algebra. Further argument: This evil science was named by Iranian scholars al-ǧabr and is certainly a Muslim plot to ruin the USA.

  2. It may be important to put this in the much larger context of the other end of the cycle, when all the dollars we are sending out into the world come home to roost. Right now, we need deficits to fund ongoing current account deficits, along with growth and other leakages. But we will have to bring federal balances much closer to balance if this tide ever reverses.. if we successfully convince China to unload its dollars, and the dollar no longer is the world-wide reserve currency. Then spending coming back to the US could cause inflation, and our current lax policy would need to be run in reverse, to some extent, collecting all those excess dollars and shredding them. This would be mitigated by ongoing targeted inflation, domestic growth, etc., so the scale would not be quite the reverse of the large deficits we are running now, but still.

  3. Re: to Burk Braun -China "unloading its dollars" would not alter anything. The reason is that whoever China unloaded its dollars to would then own those dollars. So there would be the same amount of dollars.For example, suppose that China trades all its dollars to Germany in exchange for Euros. Now Germany has just as many dollars as China used to have.The "tide" that would have to reverse would be the actual difference between net exports imports and net imports.

  4. An interested, patient person can eventually spend enough time with you folks to see there is some sense in what you say. And this is a good post, I think. Except for that "to the penny" line. (I don't care if it's true. It sounds like it must be false.) But since you bring it up, I think you'd be more effective if you disentangle yourselves from the balance sheets, and tell the truth in a way that "any idiot with a third-grade education could recognize."Art

  5. Very well done Stephanie. I really like the simplicity of this presentation of the sectoral balance model.

  6. Stephanie, I agree with your comment; however, the gov't seems to insist on selling debt for it's existing deficits which pulls dollars out of the private economy and nets the gov't to zero. (taxes + debt issuance = spending) Now, much of these dollars pulled out of the private economy are likely dormant savings (money with 0 velocity). So in the scenario I describe, gov't spending is best viewed as "forced investment" into the economy, is it not? How does a chartalist respond to the idea that gov't spending does not actually add $ to the private economy because of debt issuance? Thanks.

  7. Hello, I am new to this blog. I think I understand everything in this entry with one exception:So the government's deficit is the inverse of the private sector's surplus. OK, but how does this work considering private bank's abilities to manufacture money through the multiplier effect? How does that increase the deficit?I am a novice, so I appreciate your patience!

  8. Randall Wray and Will Black wrote for Huffpo on foreclosures – that's a foot in the door. Is there a chance to see a nice "MMT for dummies" blog on Huffpo to counter all the deficit dove epidemic? Peter

  9. The Arthurian – you are right – it could be simplified to a 3rd? grade game with the King & the People: The King spends coins (pennies), and takes them back in taxes from the People. The number of coins the king spends – the number taken in taxes = the Deficit. This equals the coins that the People get. To the penny. The End. QED. The 3rd graders complain: Duh!!! – we are mature 3rd graders, not kindergarten babies.Something tells me adults used to understand this, and that it took the human race quite some time to learn the ignorance represented by mainstream economics.

  10. Steven Stark: The key phrases answering your question in Professor Kelton's post are: "firms and households COMBINED" and "NET financial assets". When private banks or entities "manufacture money" what they create is "bank money" – it is actually a loan to someone: s/he owes the bank some $ (his liability, the bank's asset) and gets a bank deposit (his asset, the bank's liability) in return. When you COMBINE the balance sheets of a lender and a borrower, the NET result is a big fat ZERO. This is always true – and applied to the govenment versus the private sector is the whole point of the post. The net financial assets of the private sector can come only from the government, the only entity with the power to create net financial assets – liabilities of the government itself. Bank lending makes no direct change at all in the government deficit.

  11. ANother — Entice, or fail.Art

  12. We understand this. Duh! MMT proponents who go around telling everyone else they are idiots should step back and spend a little time with circuit theory and the mechanics of bank credit. Once you understand the whole loop, come back and tell me how stupid I am! The King is not the only one making pennies.

  13. Stephen, Let me take a shot. If you are talking about the "money multiplier" it is false. Banks create credit "endogenously" that is, prior to reserves. They do not need reserves to create a loan. All MMT proponents (like this site) will tell you this. However, the "velocity" of money, i.e. how bank credit for a capitalist becomes a worker's wages, or an input to another's capitalists production, etc, is very much in dispute. MMT proponents will tell you that since bank credit is always matched with debt dollar for dollar, the private sector cannot create money. Either way this process will not increase the gov't deficit. Only gov't spending in excess of taxes collected can do that. Keep reading, there is good stuff here as well as Billy Mitchell's blog and Warren Mosler's blog (Center of the Universe). For more on circuit theory and workings of the private sector in absence of gov't, see Steve Keen. And say goodbye to your neoclassical notions. Good luck!

  14. Anonymous,Thanks for tackling Stephen's question. One small quibble. MMT proponents would not (or should not) say that the private sector cannot "create money". What they would (or should) say is that "the private sector cannot create net financial assets". Endogenous money (and circut theory) sits quite comfortably with us. Loans create deposits, and newly created deposits become part of the money supply. But, as you point out, there has been no "net" increase in the private sector's holding of financial assets as a result of this (endogenous) lending, since assets and liabilities of the private sector increased 1-1.

  15. Agreed, however, the same could be said of government spending since they borrow from the private sector to fund deficits (shame!) which adds no net increase of the private sector's holding of assets, either. MMT leaves this out and, in fact, argues the opposite. Also, consider an interest only loan from a bank. If the debt is not repaid but the credit money continues to float around the circuit, there is at least an excess of money in the system, since it is never destroyed through debt expiration. It could be argued ad nauseum whether this is sustainable for the debtor in the long run, but at least an argument could be made that a private credit system in absence of gov't spending could be sustainable.IMHO, MMT will become much more credible when they put it together with circuit theory and argue EXPLICITLY that1. credit money will always fail (because assets to liabilities are 1:1)2. stop insisting that gov't deficits add wealth to the private sector (they don't if the gov't sells debt) and 3. start arguing the obvious but rarely spoken corollary that the gov't needs to add net assets to the system to make it function and therefore should stop issuing debt. Cheers!

  16. Anonymous,You are just plain wrong on this point. Deficit spending results in a net addition of financial assets to the private sector. "Borrowing" doesn't change that fact. I will work it out for you, but it will take me a bit of time to do it (I'm going to show you ALL of the actual balance sheet entries). Since I'm going to need to draw the T-accounts, it is probably best to simply make it a new blog post. Watch for it. I have a lot on my plate today. I may not get it done until tomorrow.

  17. Definitely looking forward to it!

  18. Thanks to all for helping to explain this to me.So my new understanding is that the money supply can increase (and potentially inflation) through the multiplier effect, though net financial assets remain the same. I hope that this is right, but any corrections are appreciated.I very much look forward to a post on how the government issuing debt can still increase net assets. Thanks!

  19. @anonymous. Just a quick answer before Stephanie provides her detailed answer. Let me address the first part of your second claim (government decides may not increase private saving). At the aggregate level the following identity holds (circuitists are probably the economists who have emphasized this the most):S = I + (G – T) + NXwith S private domestic saving, I private domestic investment, G government spending, T taxes, and NX net exports. G – T is the government deficit. This is an accounting identity that holds regardless of any theoretical framework. S is nominal saving, it represents the addition to nominal net worth (NW) of the private sector: NWt = NWt-1 + St.Thus, government deficit always adds to private sector net worth anytime it occurs, under any monetary regime. Let me now address the second part of your second claim: that by selling debt, governments do not add to private net wealth.Assume that first, the government decides to buy goods and services by issuing bank notes to private households and companies. This cash hoard represents an increase in saving by the private sector (S goes up). (Note: this injection of cash must occur before bonds can be issued: bonds drain cash/reserve)Second, the government decides to offer bonds to the private sector. Some households and companies will accept to give up their cash for bonds because the latter provide interest income.At the time of issuance, the switch from cash to bond does not change S indeed as long as the switch occurs at par. If households buy bond at a discount then net worth increases for the private sector (and decreases for the government). Overtime, the net worth of the private sector will grow because of interest earnings.PS: Many of us of dealt with the identity and its implications for macroeconomics, check the older posts at your convenience.

  20. Anonymous and StevenThe short answer is this. The spending comes first and the debt issuance comes after the fact. The govt actually injects the money that is then converted to a debt instrument.

  21. "Eric Tymoigne said… the government decides to buy goods and services by issuing bank notes to private households and companies…(Note: this injection of cash must occur before bonds can be issued: bonds drain cash/reserve)"And Greg seconded: "The spending comes first and the debt issuance comes after the fact." Ok, THAT first step is what perplexes me, and I guess so many others. It is, after all, the opposite of what we've always been told, even if we don't believe those who've been telling us it. (They have THEIR agenda.)I think many of us do get the analytics; we don't know or understand the mechanics.

  22. DaveGet ready for this! Brace yourself! Are you sitting down?The spending is done…………….out of thin air!! Which is of course the only place it can come from unless you treat our worlds money like a poker game with a fixed number of chips.There are those, not really realizing it (although many do realize it and like it) that do treat our monetary system as a zerosum game. Of course this IS a way to set it up, gold standards were that way, but they eventually result in collapse as more and more people demand capital for their projects in a growing economy. As the demand for capital rises in a fixed supply system what happens…. the price of money escalates. When everyone with credit demands to get paid back with gold……………….crash! Fixed quantity money systems will ALWAYS end badly in a growing world. Of course unlimited money doesnt work out too well either so ………… here we are with the $64,000 question.The fixed qty system ends with defaults, the other system CAN end with devaluing.

  23. Thanks Eric, going to let that rattle around in the cage for a bit. Looking forward to Stephanie's explanation as well.

  24. The Arthurian: You asked for simple. I gave you simple. Anonymous: There really isn't anything more going on than the King and pennies going back and forth to the People involved in proving that government deficits = private savings. Banks etc are just "smoke and mirrors", changing nothing. Banks can only create bank credit, bank money, which for most but not all purposes is equivalent to government made high-powered money. The King IS the only one making pennies = government money = government credit = currency, reserves, bonds etc. Any entity is the only one who can change its own financial position, agree to trade with, donate to, extend credit or go into debt with someone else. (With the exception of government taxation). (Or I guess you could try robbing the Mint- good luck).Bank money is for almost all purposes as good as government money, because banks have the power to borrow government money at will – get government pennies (reserves), but they still owe the government those pennies. They can only change their own financial positions, not that of the government versus the private sector. You can track each particular penny – Indian head cent, wheatie, S VDB each date minted , (equivalent to distinguishing between $ & bonds) and the widgets and baseball cards the people are trading for them, and whether the King is using his right hand or left hand (Fed or Treas) in giving and receiving the pennies, but this is not the essence. The 3rd? grade game is the essence. One can read reports of the council of economic advisers to the president which are not consistent with understanding the King and the Pennies – I was a while ago until I metaphorically threw it across the room (as much as one can reading online) If you want to call those guys idiots, fine with me. Kindergartners or the 3 Stooges would often do better.

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