Tag Archives: Fiscal Policy

The Perfect Fiscal Storm: Causes, Consequences, Solutions

Posted on April 1, 2011 by admin | 10 comments

By L. Randall Wray

Approximately a decade ago I wrote a paper with a similar title, announcing that forces were aligned to produce the perfect fiscal storm. What I was talking about was a budget crisis at the state and local government levels. I had recognized that the economy of the time was in a bubble, driven by what I perceived to be unsustainable deficit spending by the private sector—which had been spending more than its income since 1996. As we now know, I called it too soon—the private sector continued to spend more than its income until 2006. The economy then crashed—a casualty of the excesses. What I had not understood a decade ago was just how depraved Wall Street had become. It kept the debt bubble going through all sorts of lender fraud; we are now living with the aftermath.

Still, it is worthwhile to return to the “Goldilocks” period to see why economists and policymakers still get it wrong. As I noted in that earlier paper:

It is ironic that on June 29, 1999 the Wall Street Journal ran two long articles, one boasting that government surpluses would wipe out the national debt and add to national saving—and the other scratching its head wondering why private saving had gone negative. The caption to a graph showing personal saving and government deficits/surpluses proclaimed “As the government saves, people spend”. Almost no one at the time (or since!) recognized the necessary relation between these two that is implied by aggregate balance sheets. Since the economic slowdown that began at the end of 2000, the government balance sheet has reversed toward a deficit that reached 3.5% of GDP last quarter, while the private sector’s financial balance improved to a deficit of 1% of GDP. So long as the balance of payments deficit remains in the four-to-five percent of GDP range, a private sector surplus cannot be achieved until the federal budget’s deficit rises beyond 5% of GDP (as we’ll see in a moment, state and local government will continue to run aggregate surpluses, increasing the size of the necessary federal deficit). [I]n recession the private sector normally runs a surplus of at least 3% of GDP; given our trade deficit, this implies the federal budget deficit will rise to 7% or more if a deep recession is in store. At that point, the Wall Street Journal will no doubt chastise: “As the people save, the government spends”, calling for a tighter fiscal stance to increase national saving!

Turning to the international sphere, it should be noted that US Goldilocks growth was not unique in its character. [P]ublic sector balances in most of the OECD nations tightened considerably in the past decade–at least in part due to attempts to tighten budgets in line with the Washington Consensus (and for Euroland, in line with the dictates of Maastricht criteria). (Japan, of course, stands out as the glaring exception—it ran large budget surpluses at the end of the 1980s before collapsing into a prolonged recession that wiped out government revenue and resulted in a government deficit of nearly 9% of GDP.) Tighter public balances implied deterioration of private sector balances. Except for the case of nations that could run trade surpluses, the tighter fiscal stances around the world necessarily implied more fragile private sector balances. Indeed, Canada, the UK and Australia all achieved private sector deficits at some point near the beginning of the new millennium.

As we now know, my short-term projections were not too bad, but the medium-term projections were off. The Bush deficit did grow to 5% of GDP, helping the economy to recover. But then the private sector moved right back to huge deficits as lender fraud fueled a real estate boom as well as a consumption boom (financed by home equity loans). See the following chart (thanks to Scott Fullwiler):

This chart shows the “mirror image”: a government deficit from 1980 through to the Goldilocks years is the mirror image of the domestic private sector’s surplus plus our current account deficit (shown as a positive number because it reflects a positive capital account balance). During the Clinton years as the government budget moved to surplus, it was the private sector’s deficit that was the mirror image to the budget surplus plus the current account deficit. This mirror image is what the Wall Street Journal had failed to recognize—and what almost no one except MMT-ers and the Levy Economic Institute’s researchers understand. After the financial collapse, the domestic private sector moved sharply to a large surplus (which is what it normally does in recession), the current account deficit fell (as consumers bought fewer imports), and the budget deficit grew mostly because tax revenue collapsed as domestic sales and employment fell.

Unfortunately, just as policymakers learned the wrong lessons from the Clinton administration budget surpluses—thinking that the federal budget surpluses were great while they actually were just the flip side to the private sector’s deficit spending—they are now learning the wrong lessons from this crash. They’ve managed to convince themselves that it is all caused by government sector profligacy. Especially, spending on public sector workers.

For example, Wisconsin Governor Walker’s attack on workers has been taken on the pretext that state employee wages and pensions have driven the budget into deficit. We all know that is ridiculous. The reality is simple: Wall Street crashed the economy, crashed state revenues, and crashed workers’ pensions. Washington responded with a massive bail-out for Wall Street—perhaps $25 trillion worth. It gave a mere pittance to “Main Street” in its $1 trillion stimulus package. Since the recession manufactured on Wall Street cost the economy a lot more than that, Main Street is not on the road to recovery. No one is projecting that jobs will return for many more years. It is delusional to believe that economic recovery can really get underway until we have added 8 million jobs.

In other words, the fiscal storm that killed state budgets is the same fiscal storm that created federal budget deficits. You cannot lose about 8% of GDP (due to spending cuts by households, firms and governments) and over 8 million jobs without negatively impacting government budgets. Tax revenue has collapsed at an historic pace. State governments really do need to balance their budgets, and they really do need tax revenue to finance their spending or to service debt. The federal government, as the sovereign issuer of the currency is in a different situation. I will not go through the MMT approach to sovereign currency spending as all readers here are familiar with that. My point is that states really are facing a funding crisis. The federal government does not face a solvency constraint and it can always afford to buy anything for sale in dollars. Still, as we all know, Washington Beltway insiders have manufactured a fake budget crisis to serve political ends.

State spending cuts (or tax increases) will not restore their budgets. Just take a look at the results of austerity in Greece or the UK. Budget-cutting in a downturn does not reduce deficits significantly. The reason is obvious: austerity slows the economy and reduces tax revenue. Art Laffer’s supply siders were onto something, although they mostly got it the wrong way around. Yes, a booming economy will generate a movement toward balanced government budgets. They thought that tax cuts are always the answer to everything—cut tax rates and you get more tax revenue. I would not say that that never works, but it didn’t when Presidents Reagan and Bush tried it. However, if we get the Laffer Curve the right way around, we can use it to explain why austerity in a downturn just makes budget deficits worse.

In truth, state budgets will not recover before the economy recovers. And state austerity will just make the economy worse. So, as a Thatcher might say: TINA: there is no alternative–to federal government stimulus, that is. I realize that goes against the deficit hysteria in Washington. But it is the truth.

What kind of stimulus makes the most sense? I think we need another trillion dollars, minimum. This can be split equally between aid to the states and extension of the payroll tax holiday. The federal government should provide $500 billion in block grants to the states, on a per capita basis. On the condition that they stop attacking state workers. The funds would be used to replace lost tax revenue—to cover operating expenses (and where possible, to actually increase spending on priority projects). This program would continue until economic growth and job creation reaches established thresholds. Let us say 10 million more jobs or a measured unemployment rate of 4%.

The payroll tax holiday would also be expanded, with a moratorium on taxes for both workers and employers until those thresholds are reached. Why penalize job creation with an employment-killing payroll tax? Reward firms for providing jobs by giving them tax relief. Let workers keep more of their hard-earned pay. This is the quickest and best way to give significant tax relief to most Americans. In addition, we need to stop the attacks on unemployment compensation. To be sure, jobs should always be favored over unemployment compensation—but until we get the jobs we must extend the unemployment benefits. Cutting benefits will just prevent the jobs from coming back.

These measures are only a first step. We still have a lot of damage to repair—damage caused by Wall Street’s excesses. And we will need to reign-in and prosecute the fraudsters, otherwise they will blow up the economy again. Actually, they are already trying to do that—creating yet another commodities market speculative bubble. It is looking an awful lot like 2006 all over again. However this time, we are down by 8 million jobs and trillions of dollars of household wealth. Wall Street is bubbling up even as the economy as a whole is in the trenches. This bubble will not last long. It is going to crash. That will expose the huge accounting holes in the bank balance sheets. Wall Street will want another 25 trillion dollar bail out. This time, we’ve got to follow Nancy’s dictum: just say no.

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Posted in L. Randall Wray, Policy and Reform, Taxes, The Federal Government Deficit, Uncategorized

Tagged Fiscal Policy, L. Randall Wray, Policy and Reform, Taxes, The Federal Government Deficit

Can Japan Afford Recovery? Yes. Japan Does Not Need Tax Hikes or Charity

Posted on March 31, 2011 by admin | Comments Off

By L. Randall Wray

(cross-posted with Benzinga.com)

The press is filled with speculation about the impact of Japan’s earthquake and its nuclear disaster on government finances. Prime Minister Naoto Kan said that his government is exploring sources of funding, and two-thirds of surveyed citizens are willing to accept higher taxes to pay for relief. Corporate tax cuts might be rescinded, and Japan has always favored consumption tax surcharges to reduce budget deficits. Recovery spending might add $250 to $300 billion to the government’s likely budget of $1 trillion. As everyone knows, Japan’s government debt is already 200% of GDP, and with the extra spending as well as loss of tax revenue due to the economic slowdown that is likely to befall the economy (at least temporarily), the budget shortfall will get bigger.

In a touching display of charity, the global community has responded by promising to provide funds for relief. Everyone’s favorite auto-tune singer, Britney Spears, is donating some VIP tickets to her concert; My Chemical Romance is donating a song; Adam Ant is headlining a relief show; and sports stars around the world are leading efforts to raise funds. Now, I do not want to be a killjoy, but even after two decades of economic depression, the “secret savings” of Japanese wives still average over $37,000 per household. Folks, this is not Haiti or the New Orleans that was abandoned by President Bush. This is one of the richest societies that has ever graced planet earth. What the Japanese do not need is money from abroad. They do need expertise and supplies. I was horrified to find that some of my friends in California were downing iodine pills. OMG—send THOSE to Japan, not greenbacks, songs, or concert tickets.

I do not intend to minimize Japan’s real problems, after suffering from a triple whammy of Biblical proportions: earthquake, tsunami, and nuclear meltdown. It will take a very long time to recover.

But, it would only add insult to injury to raise taxes now. It would make economic recovery much harder to attain and sustain. As a sovereign nation with its own sovereign currency, Japan can “afford” recovery—government can afford to buy anything for sale in yen that might help in the relief efforts. Japan has unemployed labor and other idle resources—both for sale in yen. To be sure, the massive destruction will create bottlenecks—it will take time to reopen some factories, to get workers back into a stable home environment so that they can work, and to mobilize productive capacity. Japan will need to increase imports of some strategic materials and supplies. But it has all the yen it needs to undertake the massive recovery effort. As in all sovereign nations, the Japanese government spends by keystrokes and so long as it can find electrons, it can credit balance sheets. And if it needs to buy some stuff in dollars, it’s got those, too.

If the recovery really gets underway, aggregate demand (to replace housing, autos, factories, and infrastructure lost in the catastrophe) could superheat the economy. Inflation pressures might build. Now, THAT would be the time to raise taxes. Not to “pay for” government spending, but to take some of the fire out of an overheated economy. Better yet, relief and reconstruction will need to be planned. Yes, I know that scares the pants off the neolibs, but neither war nor reconstruction can be left to “market forces”. The aforementioned bottlenecks will generate price pressures—and, worse, price gouging—long before full employment is reached. Coordination together with wage and price controls (or “guidelines”) will let the economy generate sufficient steam to rebuild the nation without excessive inflation.

Unfortunately, Japanese policymakers have shown over the past two decades that they usually lose nerve long before they produce a sustainable recovery. They frequently adopt consumption taxes and/or spending constraints, and rely on monetary policy to overcome fiscal drag. It never does. Japan has been test-running Chairman Bernanke’s quantitative easing for 20 years, with exactly the same results that we observe now in the US: nada, zip, niente. Zero interest rates, if anything, depress the economy—especially if you have a whole lot of household saving (and no debt) in the form of government bonds that earn you little income. Sound familiar? If Helicopter Ben has his way, we will see another 17 years of this in the US.

But what about the mountains of Japanese government debt? There is no solvency risk—it is sovereign debt, denominated in yen and serviced by keystrokes. Isn’t that inflationary? Need you ask, after 20 years of deflation? Doesn’t it cause currency depreciation? If only it would! Burden the grandkids? They are inheriting the treasuries—all they want is for the BOJ to raise interest rates so they can clip some coupons.

Clearly, it is not all hunky dory in Japan. Aside from the current calamity, Japan is aging and losing its workforce. Its firms have been offshoring production for four decades so that even the non-elderly are not working. Jimmy Carter’s “national malaise” jumped the American ship and took up home in Japan—with households responding by ramping up savings. If it weren’t for American consumers, Japan Inc. would have practically no markets.

But these problems cannot be resolved by efforts to downsize government and its deficit. Indeed, the rational response to both the immediate problems as well as the longer-term trends is more government spending and less taxes.

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$50 Billion in Infrastructure Spending: A drop in the Bucket

Posted on September 7, 2010 by admin | 9 comments

By Eric Tymoigne

The White House released the following statement regarding its new recovery plan: “The President today laid out a bold vision for renewing and expanding our transportation infrastructure – in a plan that combines a long-term vision for the future with new investments. A significant portion of the new investments would be front-loaded in the first year.”

This front load is worth $50 billion…a lot of money…but an insignificant amount compared to the size of what is needed. It is not a bold vision it is a very timid vision. Don’t believe me? Ask the American Society of Civil Engineers. In its 2009 Infrastructure Report Card, it gave a D average to US infrastructures and recommended $2.2 trillion of dollars of spending over the next 5 years. And that is just to bring current infrastructures back to good condition; trillions more are needed to respond to growing needs.

Money is not a problem for the federal government, all this could be started tomorrow like we have done to finance wars, bail outs the financial sector and other wasteful items. We did it before, when the country had a truly bold vision and was much less wealthy, and we could do it again. Besides current infrastructures, we need to start to use our underused resources (especially labor) to address the future needs of our aging population and our environmental problems: education, infrastructure, social networks, technology, energy, food production, and many others sectors need help.

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Posted in Eric Tymoigne, Uncategorized

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More Reasons to Doubt Rogoff and Reinhart

Posted on August 4, 2010 by admin | 8 comments

By Yeva Nersisyan

With unemployment expected to remain high in the U.S. and Europe and the possibility of a double-dip recession growing stronger, some sensible voices are calling for another round of fiscal stimulus. And then there are others who not only argue that we don’t need more stimulus, but make a case for starting to cut spending today, notwithstanding a very fragile “recovery.” Ken Rogoff (see here), who has become the de-facto authority on the issue of sovereign deficits and debt (together with his co-author, Carmen Reinhart), in a recent FT article is trying to make the case for the redundancy of further economic stimulus. Subpar economic performance and unemployment are the usual companions of post-financial crisis recovery, he argues, hence there is no need for a “panicked fiscal response” (even Secretary Geithner has cited their research to demonstrate that the current slow pace of recovery is normal). Rogoff goes on to argue that the long-term effects of government debt accumulation on growth shouldn’t be ignored. The theoretical and empirical bases for his arguments are found in his recent book with Reinhart, This Time is Different, as well as an NBER paper, “Growth in Time of Debt”. This paper, similar to the book, has been very popular, especially among those needing empirical justification for their anti-fiscal policy stance. While the RR book focuses on the short-run, immediate impacts of sovereign debt (i.e. financial and economic crises), the focus of the paper is the impact of sovereign debt on long-term growth. In this blog I want to give a quick, critical evaluation of the paper (a longer version can be found here).

When orthodox economists start their empirical research regarding the long-term impact of deficits and sovereign debt, they do not ask whether deficits contribute to or inhibit long-term economic growth. They do not ask, because they already “know” the answer, as the ECB put it: “Although fiscal consolidation may imply costs in terms of lower economic growth in the short run, the longer-run beneficial effects of fiscal consolidation are undisputed.” (ECB, Monthly Bulletin, June, 2010). What they want to find is some threshold for deficit-to-GDP and debt-to-GDP ratios beyond which debt becomes detrimental to growth. With this goal in mind, Rogoff and Reinhart embark on a “scientific” journey through time and space.

Their method is actually quite simple: they construct some arbitrary ranges for debt-to-GDP ratios (0-30, 30-60, 60-90, >90) and take the average of growth rates for each range. They then take the average of these averages for a large number of countries and conclude that when the government debt-to-GDP ratio crosses the threshold of 90% (again, an arbitrary number), median growth rates fall by one percentage point and the average falls even more. This limit is the same for developed and developing countries, however, when it comes to external debt (which is defined in their book as both public and private debt issued in a foreign jurisdiction, and usually, but not always, denominated in foreign currency), the threshold is much lower, just 60% of GDP. Once a country crosses this lower external debt threshold, annual growth declines by about 2 percentage points and at very high levels, the growth rate is cut almost in half.

Interestingly, however, average growth rates don’t monotonically decline, i.e. the average rate of growth is higher when debt-to-GDP ratio is in the 60-90% range than the lower range of 30-60%. In addition, growth rates don’t slow down for all the countries in their sample. For some countries the average growth rate is higher when debt is over 90% of GDP than for lower levels of debt. Reinhart and Rogoff don’t point out this “anomaly,” nor do they offer any explanations. More importantly, since they take the average of averages of a number of countries, it is possible that countries like the U.S. may drive the results for the whole group. They single out the case of the U.S. in their paper to demonstrate their results. However, a closer look shows that they only have 5 data points for the U.S. when the debt-to-GDP ratio was over 90%. This is only 2.3% of the total of 216 observations. Moreover, 3 out of these 5 observations are for the years 1945, 1946 and 1947, the period after WWII when government debt was high due to war spending. In this period, growth slowed down significantly as the government was withdrawing war spending from the economy. In 1946 alone, GDP contracted at a pace of -10.9%. Rogoff and Reinhart fail to even mention this in their paper. Similar situations might be true for many other countries, where high levels of debt-to-GDP follow extreme economic or political events.

But what is even more important is that what they find in the data is merely a correlation. The causation then is imposed by Reinhart and Rogoff with explanations based on Barro’s Ricardian equivalence theory. “The simplest connection between public debt and growth is suggested by Robert Barro (1979). Assuming taxes ultimately need to be raised to achieve debt sustainability, the distortionary impact imply is likely to lower potential output” [sic].

There is no doubt about the correlation between high debt-to-GDP ratios and low economic growth found in the data. However, there is a more sensible explanation for this correlation. As explained in many past posts on this blog, the government budget balance automatically goes into deficit in a recession leading to an accumulation of public debt. Besides, GDP, the denominator of the ratio shrinks making the ratio even larger. It is sufficient to look at what happened during this most recent crisis to see this. The average rate of growth has been -0.23% for the recession years 2007-2009. At the same time, government debt held by the public has increased from 36% of GDP in 2006 to about 52% in 2009. So if you look at the data, the rate of growth was 2.7% in 2006 corresponding to a debt-to-GDP ratio of 36%. In 2009 growth was -2.6% with a corresponding debt-to-GDP ratio of 52%. Hence there is a correlation between slow growth and high levels of debt which is not surprising. But unless you want to argue that the current recession was caused by high levels of government debt, then it is obvious that causation runs from slow growth to high debt and not the other way around as Reinhart and Rogoff claim.

They also find that growth deteriorates significantly at external debt levels of over 60% and that most default on external debt in emerging economies since 1970s has been at 60% or lower debt-to-GDP ratios (which is the Maastricht criteria). While this might be a surprising finding for them, it should be clear why countries are not tolerant to external debt which is almost always denominated in foreign currency. When a government borrows in foreign currency, even low levels of indebtedness can be unsustainable since the government is not able to issue that foreign currency to meet its debt obligations. As countries need to earn foreign exchange from exports, a sudden reversal in export conditions can render the country unable to meet its foreign debt obligations leading to a crisis and slower growth. Sovereign governments, on the other hand, do not face any financial constraints and cannot run out of their own currency as they are the monopoly issuers of that currency. They don’t need to increase taxes in the future (a la Barro) to pay off the debt as they make interest payments on their “debt” as well as payments of principal by crediting bank accounts, meaning that operationally they are not constrained on how much they can spend. See here for more on this.

While many experts believe that there is an acute possibility of a double-dip recession in the U.S. (see here) and other developed nations, Ken Rogoff is not one of them. And even if we do face the threat, he argues, monetary policy will suffice (if anything, this crisis has demonstrated the ineffectiveness of monetary policy (interest rate management to be more precise) not to be confused with the massive lender-of-last resort operations that the Fed undertook to stabilize the financial system).

Even if there was no threat of a double-dip recession, one could rightly argue that the current high levels of unemployment and underemployment require more government spending. Rogoff’s argument, however, is that sustained high unemployment is the normal consequence of a financial crisis and hence he seems to conclude that fiscal measures to solve the unemployment problem are unnecessary. This is very bad policy advice – we know we have a problem (unemployment), we know how to solve it (public works), but we shouldn’t do so for fear of growth slowing or markets disciplining the government at some indefinite time in the future, a fear based on the wobbly research of Reinhart and Rogoff.

To summarize, the Rogoff and Reinhart research is not a scientific quest but merely a journey with a set destination. It is not based on any sensible theory, and the statistical analysis is of questionable quality as well. Government deficits and debt largely mirror what goes on in the private sector. There are no magic numbers for deficit and debt ratios applicable to all countries and all times. Devising such ratios is a useless exercise.

Even in better times, the U.S. economy is operating with considerably high levels of unemployment and underemployment (see here), underscoring the necessity of government intervention in the economy. In a recession as the private sector cuts back its spending and tries to de-leverage, the role of government, as the only entity in the economy that can run persistent deficits without facing solvency issues, becomes especially important. Regardless of whether there is a threat of a double dip recession, the government should act to solve the unemployment problem through direct job creation TODAY. High levels of unemployment are not compatible with a democratic society.

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Posted in The Federal Government Deficit, The National Debt, Uncategorized, Unemployment

Tagged Fiscal Policy, The Federal Government Deficit, The National Debt, unemployment

The CBO’s Misplaced Fear of a Looming Fiscal Crisis

Posted on July 29, 2010 by admin | 14 comments

By Eric Tymoigne

The Congressional Budget Office (CBO) has just released an 8-page brief titled “Federal Debt and the Risk of a Fiscal Crisis.” In it you will find all the traditional arguments regarding government deficits and debt: “unsustainability,” “crowding out”, bond rates rising to “unaffordable” levels because of fears that the Treasury would default or “monetize the debt,” the need to raise taxes to pay for interest servicing and government spending, the need “to restore investor’s confidence” by cutting government spending and raising taxes. This gives us an opportunity to go over those issues one more time.

“growing budget deficits will cause debt to rise to unsupportable levels”

A government with a sovereign currency (i.e. one that creates its own currency by fiat, only issues securities denominated in its own currency and does not promise to convert its currency into a foreign currency under any condition) does not face any liquidity or solvency constraints. All spending and debt servicing is done by crediting the accounts of the bond holders (be they foreign or domestic) and a monetarily-sovereign government can do that at will by simply pushing a computer button to mark up the size of the bond holder’s account (see Bernanke attesting to this here).

In the US, financial market participants (forget about the hopelessly misguided international “credit ratings”) recognize this implicitly by not rating Treasuries and related government-entities bonds like Fannie and Freddie. They know that the US government will always pay because it faces no operational constraint when it comes to making payments denominated in a sovereign currency. It can, quite literally, afford to buy anything for sale in its own unit of account.

This, of course, as many of us have already stated, does not mean that the government should spend without restraint. It only means that it is incorrect to state that government will “run of out money” or “burden our grandchildren” with debt (which, after all, allows us to earn interest on a very safe security), arguments that are commonly used by those who wish to reduce government services. These arguments are not wholly without merit. That is, there may well be things that the government is currently doing that the private economy could or should be doing. But that is not the case being made by the CBO, the pundits or the politicians. They are focused on questions of “affordability” and “sustainability,” which have no place in the debate over the proper size and role for government (a debate we would prefer to have). So let us get to that debate by recognizing that there is no operational constraint – ever – for a monetarily sovereign government. Any financial commitments, be they for Social Security, Medicare, the war effort, etc., that come due today and into the infinite future can be made on time and in full. Of course, this means that there is no need for a lock box, a trust fund or any of other accounting gimmick, to help the government make payments in the future. We can simply recognize that every government payment is made through the general budget. Once this is understood, issues like Social Security, Medicare and other important problems can be analyzed properly: it is not a financial problem; it is a productivity/growth problem. Such an understanding would lead to very different policies than the one currently proposed by the CBO (see Randy’s post here).

“A growing portion of people’s savings would go to purchase government debt rather than toward investments in productive capital goods such as factories and computers.”

First, this sentence seems to imply that government activities are unproductive (given that, following their logic, Treasury issuances “finance” government spending), which is simply wrong, just look around you in the street and your eyes will cross dozens of essential government services.

Second, the internal logic gets confusing for two reasons. One, if people are so afraid of a growing fiscal crisis, why would they buy more treasuries with their precious savings? Why not use their savings to buy bonds to fund “productive capital goods”? Using the CBO’s own logic, higher rates on government bonds would not help given that a “fiscal crisis” is expected and given that participants are supposed to allocate funds efficiently toward the most productive economic activity (and so not the government according to them). Second, we are told that “it is also possible that investors would lose confidence abruptly and interest rates on government debt would rise sharply.” I will get back to what the government can do in that case, but you cannot get it both ways; either financial market participants buy more government securities or they don’t.

Third, this argument drives home the crowding-out effect. I am not going to go back to the old debates between Keynes and others on this, but the bottom line is that promoting thriftiness (increasing the propensity to save out of monetary income) depresses economic activity (because monetary profits and incomes go down) and so decreases willingness to invest (i.e. to increase production capacities). In addition, by spending, the government releases funds in the private sector that can be used to fund private economic activity; there is a crowding-in, not a crowding-out. This is not theory, this is what happens in practice, higher government spending injects reserves and cash in the system, which immediately places downward pressure on short-term rates unless the Fed compensates for it by selling securities and draining reserves (which is what the Fed does on a daily basis).

“if the payment of interest on the extra debt was financed by imposing higher marginal tax rates, those rates would discourage work and saving and further reduce output.”

No, as noted many times here, all spending and servicing is done by crediting creditor’s account not by taxing (or issuing bonds). Taxes are not a funding source for monetarily-sovereign governments, they serve to reduce the purchasing power of the private sector so that more real resources can be allocated to the government without leading to inflation (again all this does not mean that the government should raise taxes and takeover the entire economy; it is just a plain statement of the effects of taxation). All interest payments on domestically-denominated government securities (we are talking about a monetarily-sovereign government) can be paid, and have been met, at all times, whatever the amount, whatever their size in the government budget.

“a growing level of federal debt would also increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to manage its budget, and the government would thereby lose its ability to borrow at affordable rates.”

If the US Treasury cannot issue bonds at the rate it likes there is a very simple solution: do not issue them. This does not alter in any way its spending capacity given that the US federal government is a monetarily-sovereign government so bond issuances are not a source of funds for the government. Think of the Federal Reserve: does it need to borrow its own Federal Reserve notes to be able to spend? No, all spending is done by issuing more notes (or, more accurately, crediting more accounts) and if the Fed ever decided borrow its own notes by issuing Fed bonds to holders of Federal Reserve notes (a pretty weird idea), a failure of the auction would not alter its spending power. The Treasury uses the Fed as an accountant (or fiscal agent) for its own economic operations; the “independence” of the Fed in making monetary policy does not alter this fact.

“It is possible that interest rates would rise gradually as investors’ confidence declined, giving legislators advance warning of the worsening situation and sufficient time to make policy choices that could avert a crisis.”

It is always possible that anything can happen, but what is the record? The record is that there is no relationship between the fiscal position of the US government and T-bond rates. Massive deficits in WWII went pari passu with record low interest rates on the whole Treasury yield curve. With the help of the central bank, the government made a point of keeping long-term rates on treasuries at about 2% for the entire war and beyond, despite massive deficits. There is a repetition of this story playing out right now, and Japan has been doing the same for more than a decade. Despite its mounting government debt, the yield on 10-year government bonds is not more than 2% as of July 2010. In the end, market rates tend to follow whatever the central bank does in terms of short-term rates, not what the fiscal position of the government is.

As we already stated on this blog before, a simple observation of how government finance operates shows that government spending injects reserves into the banking system (pressing down short-term interest rate), while the payment of taxes reduces/destroys reserves (pushing short-term rates up). The Fed has institutions that allow it to coordinate on a daily basis with the Treasury (they call each other every day) to make sure that all these government operations do not push the interest rate outside the Fed’s target range.

“If the United States encountered a fiscal crisis, the abrupt rise in interest rates would reflect investors’ fears that the government would renege on the terms of its existing debt or that it would increase the supply of money to finance its activities or pay creditors and thereby boost inflation.”

That’s a repeat of the first question but with a bit of elaboration. The US government cannot default on its securities for financial reasons, it is perfectly solvent and liquid. (Sovereign governments can, as we have conceded on this blog, refuse to pay – e.g. Japan after the war – but that is because it was unwilling to repay, not because it was unable to pay.) Thus, despite Reinhart and Rogoff’s warnings, the credit history of the US government (and any monetarily-sovereign government) remains perfect. No government with a non-convertible, sovereign currency has ever bounced a check trying to make payment in its own unit of account.

The US government always pays by crediting the account of someone (i.e. “monetary creation”). If the creditor is a bank, this leads to higher reserves, if it is a non-bank institution it leads also to an increase in the money supply. It has been like this from day one of Treasury activities. It is not a choice the government can make (between increasing the money supply, taxing or issuing bonds); any spending must lead to a monetary creation; there is no alternative. Again taxes and bonds are not funding sources for the US federal government; however they have important functions. Taxes help to keep inflation in check (in addition to maintaining demand for the government’s monetary instruments). Bond sales allow the government to deficit spend without creating excessive volatility in the federal funds market. If financial market participants want more bonds, the Treasury issues more to keep bond rates high enough for its tastes; if financial market participants do not want more treasury bonds, the government does not issue to avoid raising rates. The US Treasury (and any monetarily sovereign government as long as they understand it) has total control over the rate it pays on its debts; whether the government understands this or not is another question. A monetarily sovereign government does not have to pay “market rates” in order to convince markets to hold its bonds. Indeed, it does not even have to issue securities if it does not want to. In the US, it is usually the financial institutions that beg the Treasury to issue more securities.

The recent episode of the “Supplementary Financing Program” is a very good illustration of that point. Financial market participants were crying for more Treasuries and the Fed could not keep pace. As a consequence the Treasury agreed to issue more Treasuries than expected to meet the demand and help the Fed drain reserves and thereby hit their interest rate target. According to the Federal Reserve Bank of New York (DOMESTIC OPEN MARKET OPERATIONS DURING 2008, page 28): “To help manage the balance sheet impact of the Federal Reserve’s liquidity initiatives, the Treasury announced the establishment of a temporary Supplementary Financing Program (SFP) on September 17. The program consists of a series of Treasury bills issued by Treasury, the proceeds of which are deposited in an account at the Federal Reserve, draining reserve balances from the banking sector.”

Now look how this was deformed by the Treasury (quite a few journalists and bloggers followed): “The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve. The program will consist of a series of Treasury bills, apart from Treasury’s current borrowing program, which will provide cash for use in the Federal Reserve initiatives.” No, Mr. Treasury, this was not done for funding purpose; it was done to drain reserves from the banking system. The Fed does not need any cash from the Treasury. The Fed is the monopoly supplier of cash.

A final point regarding inflation. Inflation is a potential issue, as we have always maintained. But, there is no automatic causation from the money supply to inflation (a point Paul Krugman appears to have forgotten). Inflationary pressures depend on the state of the economy (supply and demand-side factors). Most importantly, perhaps, it depends on people’s desire to hoard vs. spend cash. Even the massive deficits during WWII, when resources were fully employed, did not lead to a spiraling out of control of inflation. Finally, it is quite possible that causation actually runs the other way around – i.e. from inflation to the money supply – given the endogeneity of the money supply, but that’s a story for another day…

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Posted in Eric Tymoigne, L. Randall Wray, Social Security, Stephanie Kelton, The Federal Government Deficit, Uncategorized, Unemployment

Tagged Eric Tymoigne, Financial crisis, Fiscal Policy, L. Randall Wray, Social Security, Stephanie Kelton, The Federal Government Deficit, unemployment

Towards a Libertarian/Austrian Modern Money Theory

Posted on July 27, 2010 by admin | 31 comments

By L. Randall Wray

For reasons that I cannot fathom, the most vehement critics of Modern Money Theory (MMT) are the wingnut libertarians and Austrians (and, please, I use the term wingnut with some affection for our fellow fringe travellers). Any time there is an MMT post on this blog, or over at New Deal, Naked Capitalism, or the Huff, the comments are dominated by conspiracy theorists, haters of government, goldbugs, and victims of alien probings who are certain that MMT-ers are united in their effort to ramp up government until it consumes the entire economy. So let us try to mend fences.

First, on one level, MMT is a description of the way a sovereign currency works. Love it or hate it, our sovereign government spends by crediting bank accounts. Over the past 20 years, MMT has investigated, analyzed, and documented the sordid operational details. We can lecture for hours on the balance sheet manipulations involving the Treasury, the Fed, the primary security dealers, the special depositories, and the regular private banks every time the Treasury buys a notepad from OfficeMax. We did the work, so you do not have to do it. And believe me, you do not want to do it. You can skip directly to the conclusion: “Yes, government spends by crediting bank accounts, taxes by debiting them, and sells bonds to provide an interest-earning substitute to low-earning reserves. Q.E.D.”

A few libertarians and Austrians now get this, although instead of thanking us for a job well done, they immediately attack us for explaining how things work. Now, why would they do that? Because they fear that if we tell policymakers and the general public how things work, democratic processes will inevitably blow up the government’s budget as everyone demands that wine flow freely through the nation’s drinking fountains whilst workers retire from government jobs at age 28 on generous pensions provided at the public trough. And off we go to Zimbabwe land, with hyperinflation that destroys the currency and sucks the precious body fluids from our economy.

Ok, understood. We fear inflation, too. That has always been our message, too. Indeed, “price stability” has always been one of the two key missions of UMKC’s Center for Full Employment and Price Stability (http://www.cfeps.org/). Maybe you do not like our proposed methods of battling inflation. Fine. Show us yours. I realize that many libertarians and Austrians believe that the only foolproof method for avoiding inflation is to go back to gold. Again, fine. But don’t criticize our labor “buffer stock” scheme for its political infeasibility! Going back to the gold standard is less likely than alien abduction. (Oh, sorry, no offence intended.) Anyway, we (also) do not want black helicopters flying around dropping bags of cash; and we (also) oppose government “pump-priming” demand stimulus—the libertarians and Austrians and even Milton Friedman are correct in their argument that this would generate inflation.

So it is true that there is a second level to MMT: we use our understanding of the way money works to bring rational analysis to government policy-making. Since involuntary default is, literally, impossible for a sovereign government, we quickly move beyond fears about government deficits and debt ratios and all the other nonsense that currently grips Washington. Can we “afford” full employment? Yes. Can we “afford” Social Security? Yes. Can we “afford” to put wine in all the drinking fountains? Yes. The problem IS NOT, CANNOT BE about affordability. It is about resources. Unemployment is easy: by definition, someone who is unemployed is available to hire. So government can put them to work. Social Security is a little more difficult: can we move enough resources to the aged (plus their dependents, and people with disabilities) so that they can enjoy a comfortable, American-style, life? On all reasonable projections of demographics and US ability to produce, the answer is yes. The projections could turn out to be wrong. But if they do, affordability still will not be the problem—it will be a resource problem. Finally, wine in drinking fountains? There probably is not enough fine wine, but we could probably fill all the drinking fountains with cheap French wine. Again, it is a resource problem and if we convert the American prairies to wine production we could probably even resolve that one.

Perhaps the most important policy pushed by most MMT-ers is the Job Guarantee/Employer of Last Resort proposal. This provides a federal-government funded job to anyone who wants to work, at a uniform, basic compensation (wages plus benefits). Our libertarian/Austrian fellow travelers seem to hate this program, again for unfathomable reasons. I suspect that they have misinterpreted this to be some kind of Big Government/Big Brother program based on a weird combination of force plus welfare. The claim is simultaneously that it “forces” everyone to work, and that it also pays everyone for not working. Actually, it is a purely voluntary program, only for those who want to work. Those who will not work cannot participate. Libertarians and Austrians ought to love it. It is not Big Brother. It is not even Big Government. The jobs do not have to be provided by government at all. No one has to take a job. It is consistent with, I think, the most cherished norms of freedom-loving libertarians and Austrians.

So to sum up:

1. MMT is consistent with any size of government. It can be a small libertarian government if you like. But it issues a sovereign floating currency. It supports the currency by imposing a tax payable in that currency.

2. Job Guarantee/Employer of Last Resort is also consistent with any size of government. If you want a big private sector and small government sector, keep taxes and government spending low. That frees up resources to be used by the big private sector. But you will need the JG/ELR to take up the labor resources the private sector cannot fully employ.

3. JG/ELR can be as decentralized as you want. I think there are massive incentive problems if you have federal government pay wages of for-profit firms. So I would have federal government pay the wages in the program but have the jobs actually created and managed by: not-for-profits, local government, maybe state government, maybe only as a final last resort the federal government. Argentina experimented with cooperatives and they looked to me to be highly successful.

4. The problem with a monetary economy (you can call it capitalism if you like) is that from inception imposition of taxes creates unemployment (those looking for money to pay taxes). We scale this up to our modern almost fully monetized economy (you need money just to eat, watch TV, play on cell phones, etc) and we get everyone looking for money (and not just to pay taxes). It is sheer folly to then force the private sector to solve the unemployment problem created by the government’s tax. The private sector alone will never (never has) provide full employment. ELR/JG is a logical and empirical necessity to support the private sector. It is a complement not a substitute for private sector employment.

5. How can the belief that all ought to work, and contribute to society, rather than lay about and collect welfare be called socialism?

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Tagged Fiscal Policy, L. Randall Wray

May the Biggest Loser Win: Euroland’s Race to the Bottom

Posted on July 26, 2010 by admin | 3 comments

By L. Randall Wray

As part of the EU/IMF plan to resolve Greece’s debt crisis and to make its economy more competitive, the government announced a couple of weeks ago plans to revamp labor relations laws and social security entitlements. The minimum monthly wage for new entrants into the labor market will be decreased from 700 euros to 560 euros, and workers will be required to have 40 years of employment to receive a full pension (which has also been subject to significant reductions). And companies would face far fewer restrictions with regard to layoffs and layofff compensations–which have been cut in half. The strategy is obvious: Greece wants to win the race to the bottom in the Eurozone, that is, to win competitive advantage by having the region’s lowest and meanest living standards. That, of course, will now be an even tougher race to win, with the recent entry of Estonia into the Eurozone.

Even in the best of times, this would be a dangerous strategy. Given that all members of the Eurozone have removed trade and capital barriers and adopted a common currency, there is no possibility of gaining advantage through the normal methods of currency devaluation or by tacking tariffs onto imports. This means that trade surpluses can be achieved only by lowering costs and increasing labor productivity. Costs are cut by slashing wages and benefits; productivity is increased by working employees harder—downsizing the labor force, longer hours, shorter vacations, and postponed retirement. But every nation will adopt the same strategy. Matters are made worse by the deep global crisis. Markets for exports are depressed and tourism is down. Meanwhile, governments are cutting spending—especially in those areas that could actually help increase productivity and enhance competitiveness: public infrastructure investment and education. Lower wages and retail sales, and a smaller workforce result in collapsing government tax revenue—fueling a vicious cycle of spending cuts but falling tax revenue so that budget deficits cannot be reduced.

To be sure, Greece has had its problems. Its labor costs have grown significantly over the past decade, much faster than those of Germany and other Eurozone nations. But the notion that workers in Greece have been enjoying the fruits of an overly generous welfare state is belied by the facts. (See here) In reality, the Greeks have one of the lowest per capita incomes in Europe (€21,100), much lower than the Eurozone 12 (€27,600) or the German level (€29,400). Further, the Greek social safety nets might seem generous by US standards but are modest by European standards. On average, for 1998-2007 Greece spent only €3530 per capita on social protection benefits–slightly less than Spain’s spending and only €700 more than Portugal’s, which has one of the lowest levels in all of the Eurozone. By contrast, Germany and France spent more than double the Greek level, while the original Eurozone 12 level averaged €6251.78. Even Ireland, which has one of the most neoliberal economies in the euro area, spent more on social protection than the supposedly profligate Greeks.

Greece is also supposed to suffer from inefficiency and cronyism in its government—so its administrative costs should be higher than those of more disciplined governments such as the German and French. But this is obviously not the case as the table below demonstrates. Even spending on pensions, which is the main target of the neoliberals, is lower than in other European countries.

Table 2 shows total social spending of select Eurozone countries as a per cent of GDP. Through 2005, Greece’s spending lagged behind that of all euro countries except for Ireland, and was below the OECD average. Note also that in spite of all the commentary on early retirement in Greece, its spending on old age programs was in line with the spending in Germany and France.

Greece has one of the most unequal distributions of income in Europe, and a very high level of poverty, as the following table shows. Again, the evidence is not consistent with the picture presented in the media of an overly generous welfare state.

The proposed cuts will simply widen the gap between living standards in Greece versus those in the wealthiest Eurozone nations.

This is a race to the bottom that can only be won by the biggest loser. It is bizarre that the EU and the IMF are promoting such a contest since it is completely inconsistent with the longer-run strategy of convergence across Euroland. Indeed, it will ultimately destroy the union.

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Posted in L. Randall Wray, Policy and Reform, Uncategorized

Tagged Fiscal Policy, L. Randall Wray, Policy and Reform

Why Dean Baker has Gone off the Rails on Social Security

Posted on July 2, 2010 by admin | 20 comments

By Stephanie Kelton

Some of the members of the president’s National Commission on Fiscal Responsibility and Reform are using the trumped-up crisis in Social Security to push their decades-in-the-making agenda of privatization. For example, Andy Stern, one of the commission’s key members, wants to see the system transformed from one that guarantees a minimum standard of living to the elderly, their dependents and the disabled into one that leaves them (in whole or in part) dependent on the vagaries of the market.

Asked to comment on Stern’s privatization proposal, Dean Baker recently said:

“I don’t think it’s necessarily a bad idea …. If he’s talking about getting money out of the trust fund for that purpose, I could live with it. You’d get a higher return now that stocks are falling.”

To defend his position, Baker pointed out that the Trust Fund, which consists almost entirely of non-marketable government securities, is only earning about three percent but that “it would be reasonable to assume a six or seven point return” on funds invested in the stock market. Hmm . . .

Seven is greater than three. You can’t argue with that. That is, unless you look more closely at what privatization would actually entail.

Since President Obama’s deficit commission hasn’t proposed anything concrete (yet) – i.e. we don’t know how much of the current system they want to privatize – let’s go ahead and use George W. Bush’s privatization proposal, simply for purposes of demonstration.

In 2005, President Bush pushed for partial privation of Social Security, which would have allowed workers under the age of 55 to divert up to 4 percent of their current payroll tax contribution into their own retirement accounts. Workers who decided to participate would then depend upon benefits from two sources: (1) the (now lower) guaranteed benefit they would continue to receive from Social Security and (2) the market benefit that would accrue in the form of gains in their personal account. Clearly, the more an individual diverts into private accounts, the less they would receive in the form of a guaranteed benefit, and, hence, the more they will rely upon gains in financial markets.

Here’s the way a Senior Administration Official sold the Bush plan in 2005:

“The way that the election is put before the individual in a personal account structure of this type is that in return for the opportunity to get the benefits from the personal account, the person foregoes a certain amount of benefits from the traditional system.

Now, the way that election is structured, the person comes out ahead if their personal account exceeds a 3 percent real rate of return, which is the rate of return that the trust fund bonds receive. So, basically, the net effect on an individual’s benefits would be zero if his personal account earned a 3 percent real rate of return. To the extent that his personal account gets a higher rate of return, his net benefit would increase as a consequence of making that decision . . . .

. . . the specific trade-off that you’re making in opting for a personal account is based on your decision that you
think you can beat the 3 percent real rate of return.”

So that’s the privatization pitch: privatization offers better prospects for growth and, ultimately, a more comfortable retirement. This is especially true in the case of younger workers, because they can get in early and experience the magic of compound interest. This, apparently, is where Dean Baker is coming from.

It’s a choice that seems to make sense for those who expect their personal account to earn a rate of return that exceeds the rate of return earned on Treasury bonds (held in the Trust Fund). But is it really such a no-brainer? Let’s look more closely at the implications of diverting withholdings into personal accounts.

Investing in a personal account means foregoing a portion of the guaranteed benefits that would have been received under the traditional system. Advocates of privatization see no harm in this, since earnings on personal savings accounts should more than offset the foregone benefits. Chart 1 on page 13 of this essay provides a diagrammatic description of the role of personal savings accounts in offsetting guaranteed benefit reductions.

It works like this. When a worker agrees to establish a personal account he is effectively asking the government to lend him part of his Social Security tax so that he can invest it in the stock market. The government would monitor these loans and investments by establishing parallel accounts, a ‘notional account’ (to keep track of the loan) and a ‘personal account’ (to keep track of the investment). This means that diverted payroll contributions would be double-counted, and each account would be credited, over time, with interest – the notional account would accumulate interest at the rate of return on Treasury bonds, and the personal account would accumulate interest at the nominal portfolio rate of return, less annual fees.

To make the argument concrete, consider a highly simplified example. Suppose an individual’s notional account would equal $100,000 at retirement. If this person’s life expectancy at retirement is 20 years and the annuity draws zero interest and comes at zero administrative costs (simplifying assumptions), the annuity on this account would be $5,000. This sum – known as the “clawback” – would be deducted from the defined benefit amount, to arrive at the “benefit after clawback.” If the defined benefit (calculated using an inflation-index) would have otherwise been $12,000 per year, it will now be $7,000. Now, if the poverty-level of income is $16,000, this individual’s personal account will need to be sufficiently large (well above $100,000) to allow an additional (lifetime) benefit of $9,000 per year through annuitization.

As time goes on, the size of the clawback would grow, relative to the benefit, because the clawback would be proportional to wages, whereas the defined benefit would be fixed in real terms (i.e. indexed to prices). This would make workers increasingly dependent on the annuitized value of their personal accounts. Moreover, workers will have to pay a fee – to financial firms – to annuitize their individual accounts, a cost that could absorb as much as 10 to 20 percent of their savings, as Dean Baker showed when he was an outspoken critic of privatization in 2005.

With the size of the after-clawback benefit projected to decrease over time, it is likely that the whole private account will need to be annuitized. And, unless the stock market performs incredibly well, there is a good chance that the annuitized value of the private account will be insufficient to sustain many Americans in retirement.

The groups who are most vulnerable to this kind of shortfall are women and minorities, who make up a disproportionate share of America’s low-wage workers. This has been emphasized by Diana Zuckerman, president of the National Research Center for Women and Families, who argued that “[w]omen depend more on Social Security than men do, because women are less likely to have their own private pensions when they retire.” And, even when they do have pensions, Zuckerman said, “their pension checks are, on average, half as large as men’s are.” This means that our nation’s low-wage workers are particularly vulnerable because they are less likely to have other forms of saving, pensions, etc., to supplement Social Security in retirement.

So here we are again, this time with a Democratic president and a deficit commission stacked with conservatives posing the same question the Bush administration asked in 2005: Do you want your money in a Trust Fund that earns a 3 percent real return, or would you prefer to invest it in a personal account that might yield nearly 7 percent after inflation? Using this simple argument, people like Andy Stern will try to persuade Americans that the answer is fairly obvious.

For the sake of millions of Americans who are able to avoid the anguish of poverty only because of the benefits they receive under the current system, I hope Dean Baker will return to his roots and lead the progressive charge to preserve Social Security as we know it.

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Troubles in the Eurozone: Is a Conflict with the U.S. Far Behind?

Posted on April 19, 2010 by admin | 7 comments

By Marshall Auerback

At its most basic, our economy can be divided up into 3 sectors: there is a private sector that includes both households and firms; there is a government sector that includes both the federal government as well as all levels of state and local governments; and there is a foreign sector that includes imports and exports. As my friend Randy Wray notes (.pdf): “At the aggregate level, the dollar spending of all three sectors combined must equal the income received by the three sectors combined. Aggregate spending equals aggregate income. But there is no reason why any one sector must spend an amount exactly equal to its income. One sector can run a surplus (spend less than its income) so long as another runs a deficit (spends more than its income). This applies to households, businesses, net saving nations vs. net “dis-saving” nations, and the government sector.”

How does this work in practice? If households attempt to net save by spending less than they are earning, and businesses attempt to net save (reinvesting less than their retained earnings), then nominal incomes and real output are likely to fall. Money incomes and economic activity will tend to contract until private savings preferences are reduced (with essential goods and services taking up a larger share of household income as incomes fall), or until depreciation leaves businesses and households inclined to invest once again in durable assets. Common sense suggests that a drop in private income flows while private debt loads are high is an invitation to debt defaults and widespread insolvencies – that is, unless creditors are generously willing to renegotiate existing debt contracts en masse. Which is why any particular nation in these circumstances must either run an external surplus on its current account, or experience a rising government deficit or some combination of the two.

Of course, given the prevailing levels of government deficit hysteria in the US right now, one can see the political appeal of focusing on export led growth, along Asian lines, since a sufficiently large trade surplus will facilitate the government’s ability to cut spending and run public sector surpluses. The problem of course comes from the fact that it is impossible for all governments (in all nations) to run public surpluses without impairing growth because not all nations can run external surpluses. There has to be another nation willing to become a net importer. For nations running external deficits (the majority), public surpluses have to be associated with private domestic deficits, which is inherently constraining in a way that government deficits are not.

Historically the US private sector has spent less than its income—that is, it has run a surplus, whereas the government has run deficits. From a straight national accounts identity, then, the paradox of private sector thrift is that it is facilitated by public sector profligacy. Or another way of putting it: every time the government runs a deficit and issues a bond, adding to the financial wealth of the private sector.

Of course, the opposite would also be true. Assume we have a balanced foreign sector and that the government runs a surplus—meaning its tax revenues are greater than government spending. By identity this means the private sector is spending more than its income, in other words, it is deficit spending. The deficit spending means it is going into debt, and at the aggregate level it is reducing its net financial wealth. By extension, a country which runs a large trade deficit (as the US has persistently done for the past quarter century), needs an even greater degree of government fiscal expenditure to offset the potential “deficit” spending by the private sector.

Clearly, this financial balances approach is not well understood by most voters. Indeed, a recent poll by Douglas Schoen and Patrick Caddell suggests that the swing voters, who are key to the fate of the Democratic Party, care most about three things: reigniting the economy, reducing the deficit and creating jobs. But the latter two goals are generally incompatible, especially during major recessions. In times of high unemployment, government deficits are required to underwrite growth, given that the private sector shift to non-government surpluses has left a huge spending gap and firms responded to the failing sales by cutting back production. Employment falls and unemployment rises. Then investment growth declines because the pessimism spreads. Before too long you have a recession. Without any discretionary change in fiscal policy (now referred to in the public media as “stimulus packages”) the government balance will head towards and typically into deficit, unless the US miraculously becomes an export powerhouse along emerging Asia lines, and runs persistent current account surpluses, to a degree which allows the governments to run budget surpluses.

This is not going to happen, particularly when the largest current account surplus nations, notably Germany, cling to a mercantilist export led growth model, an inevitable consequence of that country’s aversion to increased government deficit spending. The German government’s reticence to counter any kind of shift in regard to its current account surplus is particularly significant in light of the ongoing and intensifying strains developing in the EMU nations (see here). Following the inexorable logic of the financial balances approach sketched above, then, I am now more convinced than ever that there is a “Lehman” style event waiting to happen in the euro zone. Last week’s Greek “rescue” is, as we suggested earlier, Europe’s “Bear Stearns event”. The Lehman moment has yet to come. One possible outcome of this could well be significantly larger budget deficits in the US and a substantial increase in America’s external deficit. Let me elaborate below.

In the euro zone, I now see one of two possible outcomes. Scenario 1: the problem of Greece is not contained, and the contagion effect extends to the other “PIIGS” countries, leading to a cascade of defaults and corresponding devaluations as countries exit the EMU. Interestingly enough, the country which could well be affected most adversely in this situation is France, as the country’s industrial base competes largely against countries like Italy and the corresponding competitive devaluation of the Italian currency in the event of a euro zone break-up could well destroy the French economy (by contrast, as a capital goods exporter with few euro zone competitors, Germany’s industrial base will be less adversely affected in our view).

In Scenario 2 (more likely in my opinion) we get some greater fears about other PIIGS nations (discussion is now turning to Spain, Portugal and Ireland). The EMU might well hold together but the corresponding fear of contagion might well provoke capital flight and drive the euro down to parity (or lower) with the dollar. Of course, the euro’s weakness creates other problems: when the euro was strengthening last year due to portfolio shifts out of the dollar, many of those buyers of euro bought euro denominated national government paper (including Greece). The resultant portfolio shifts helped fund the national EMU governments at lower rates during that period. That portfolio shifting has largely come to an end, making national government funding within the euro zone more problematic, as the Greek situation now illustrates.

The weakening euro and rising oil prices raises the risk of ‘inflation’ flooding in through the import and export channels. With a weak economy and national government credit worthiness particularly sensitive to rising interest rates, the ECB may find itself in a bind, as it will tend to favor rate hikes as prices firm, yet recognize rate hikes could cause a financial collapse. And should a government like Greece be allowed to default the next realization could be that Greek depositors will take losses, and, therefore, the entire euro deposit insurance lose credibility, causing depositors to take their funds elsewhere.

It’s all getting very ugly as it all threatens the value of the euro. The only scenario that theoretically helps the value of the euro is a national government default, which does eliminate the euro denominated financial assets of that nation, but of course can trigger a euro wide deflationary debt collapse. The ‘support’ scenarios all weaken the euro as they support the expansion of euro denominated financial assets, to the point of triggering the inflationary ‘race to the bottom’ of accelerating debt expansion.

So timing is very problematic. A rapid decline of the euro would facilitate a competitive advantage in the euro zone’s external sector, but it could also set alarm bells off at the ECB if such a rapid devaluation creates incipient inflationary strains within the euro zone.

What about the US? In the latter scenario, we can envisage a situation in which the combination of panic and corresponding flight to safety to the dollar and US Treasuries, concomitant with the increased accumulation of US financial assets (which arises as the inevitable accounting correlative of increased Euro zone exports) means that America’s external deficits inexorably increase. There will almost certainly be increased protectionist strains, a possible backlash against both Europe and Asia, especially if the deficit hawks begin sounding the alarm on the inexorable rise of the US government deficit (which will almost certainly rise in the scenario we have sketched out).

Assuming that the US does not wish to sustain further job losses, the budget deficit will inevitably deteriorate further, either “virtuously” (via proactive government spending which promotes a full employment policy), or in a bad way , whereby a contracting economy and rising unemployment, produce larger deficits via the automatic stabilisers moving to shore up demand as the economy falters.

How big can these deficits go? Easily to around 10-12% of GDP or higher (versus the current 8% of GDP) should a euro devaluation be of a sufficient magnitude to induce a sharp deterioration of America’s trade deficit.

What will be the response of the Obama Administration? America can sustain economic growth with a private domestic surplus and government surplus if the external surplus is large enough. So a growth strategy can still be consistent with a public surplus, but this becomes virtually impossible if the euro zone’s problems continue, as we suspect that they will.

President Obama, however, has long decried our “out of control” government spending. He clearly gets this nonsense from the manic deficit terrorists who do not understand these accounting relationships that we’ve sketched out. As a result he continues to advocate that the government leads the charge by introducing austerity packages – just when the state of private demand is still stagnant or fragile. By perpetuating these myths, then, the President himself becomes part of the problem. He should be using his position of influence, and his considerable powers of oratory, to change public perceptions and explain why these deficits are not only necessary, but highly desirable in terms of sustaining a full employment economy.

Governments that issue debt in their own currency and do not promise to convert their currency into anything else can always “afford” to run deficits. Indeed, in this context government spending financially helps the private sector by injecting cash flows, providing liquid assets and raising the net worth of some or all private economic agents. In contrast to today’s budget deficit “Chicken Littles”, we maintain that speaking of government budget deficits as far as the eye can see is ludicrous for the simple reason that as the economy recovers, tax revenue rises, the deficit automatically reduces. That’s the whole reason for engaging in deficit spending in the first place. Any projections that show the deficit continuing to climb without limit is misguided–the Pete Peterson projections, for example, will never come to pass. As we near and exceed full employment, inflation will pick-up, which reduces transfer payments and increases tax revenues, automatically pushing the budget toward surpluses. In the 220 year experience of the United States there have only been a few years when we’ve not had deficits and each time the surpluses were immediately followed by a depression or a recession. So the historical evidence here, indicates that we can run nearly permanent deficits and that when we do, it’s better for the economy. The challenge for our side of the debate is to expose these voluntary constraints for what they are and explain why the US is not a Weimar Germany waiting to happen.