Tag Archives: Stephanie Kelton

What Happens When the Government Tightens its Belt? (Part II)

By Stephanie Kelton

In a recent post, I used a simple teeter-totter diagram to show how the government’s financial balance is related to the private sector’s financial balance in a closed economy. With only two sectors – government and non-government – I showed that a government deficit necessarily implies a surplus in the private sector.

As expected, this accounting truism ruffled the feathers of a flock of readers who have been programmed to launch into an anti-government tirade at the mere mention of the public sector and to regard the dangers of deficit spending as an unimpeachable fact. And while you’re certainly entitled to your own political views, you are not, as Senator Moynihan famously said, entitled to your own facts.

Other, less impenetrable minds, agreed that the private sector’s financial position must improve as the government’s deficit increases in a closed economy, but they argued that I had not demonstrated anything meaningful because I ignored the financial flows that occur in an open economy.

I still hope to convince both groups that they are acting against their own economic interests when they support policies to balance the budget or reduce the deficit, either by raising taxes or cutting government expenditures. So let’s continue the exercise and, as promised, extend the argument to the more realistic open-economy in which we actually live.

In an open economy, income flows into and out of the domestic economy as residents and foreigners buy goods and services (exports minus imports), make and receive payments such as interest and dividends (factor income) and make net transfer payments (such as foreign aid). Each country keeps track of these payments using a balance of payments (BOP) account, which summarizes the international monetary transactions that take place between the home country and the rest of the world. The BOP has two primary components – the current account and the capital account – and we can use either one to show whether, on balance, money is flowing into or out of a country.

When we incorporate these international flows, we transform the closed-economy accounting identity I used in my previous post:

[1] Domestic Private Surplus = Government Deficit

into the open-economy accounting identity shown below:

[2] Domestic Private   =  Government  +   Current Account
Surplus                      Deficit                  Balance

or, equivalently,

[3] Domestic Private =    Government   +  Capital Account
Surplus                       Surplus                Balance

When the current account balance is positive, it means that we in the private sector (households and domestic firms) are accumulating net financial claims on foreigners. When it is negative, they are accumulating net financial claims on us. Thus, a positive current account implies a negative capital account and vice versa.

To see this in the context of the teeter-totter model, let’s initially hold the public sector’s balance constant at zero (i.e. let’s assume the government is balancing its budget so that G = T). With the government budget in balance, Uncle Sam is a “weightless” entity on the teeter-totter, so that the private sector’s financial position will simply reflect the “weight” of the capital account. Suppose, first, that the current account is in surplus (i.e. the capital account shows an equivalent deficit):

The image above depicts the benefit (to the private sector) of a current account surplus (a.k.a a capital account deficit), and it is the outcome that many of you accused me of sidestepping in my previous post. Of course, the U.S. does not have a current account surplus, so let’s address that point before moving on. (And lest anyone begin to hyperventilate, I’ll also address the fact that G ≠ T). First, the current account.

Sticking with (G = T) for the moment, we can show how a current account deficit impacts the private sector’s financial position. As the capital account moves from deficit (diagram above) into surplus (diagram below), we see that the private sector’s financial position moves from surplus into deficit.

But does this all of this hold true in the real world, or is it some kind of economic chicanery? Let’s check the facts.

Equations [2] and [3] above are not based on economic theory. They are accounting identities that always “add up” in the real world. So let’s firm up the discussion about the implications of government “belt tightening” by running through some examples using the real world data found in the table below (Hat tip to Scott Fullwilir for sharing the file. All of the data comes from the National Income and Product Accounts (NIPA) and the Flow of Funds.)

[ Click here for Sectoral Balances Data (.xlsx format) ]

Let’s begin with the data from 1998 (Q3), when the public sector deficit was just 0.01% of GDP and the current account deficit was 2.56% of GDP. Plugging these numbers into equation [2] above, the identity tells us (and the data in the table confirm) that the private sector’s balance must have been:

[2] Domestic Private Sector’s Balance = 0.01% + (-2.56% )= -2.55%

Here, we can see that the private sector’s financial position was deteriorating because it was making large (net) payments to foreigners. Because this loss of financial resources was not offset by the public sector, the private sector’s financial position deteriorated.

To see how a bigger government deficit would have improved the private sector’s financial position, let’s look at the data from 1988 (Q1). As a percent of GDP, the current account balance was 2.59%, nearly the same as before, while the government’s deficit came in at a much higher 4.2% of GDP. We can use Equation [2] to see effect of the larger budget deficit:

[2] Domestic Private Sector’s Balance = 4.2% + (-2.59%) = 1.61%

In this period, the private sector ends up with a surplus because the government’s deficit was large enough to more than offset the negative effect of the current account deficit.

Again, this is simply a property of the sectoral balance sheet identities. Whenever the government’s deficit is too small to offset a deficit in the current account, the private sector will experience a net loss. The result my ruffle your feathers, but it is an unimpeachable fact.

So let’s go back to President Obama’s comment and the reason I wrote this blog in the first place. The President said:

“[S]mall businesses and families are tightening their belts. Their government should, too.”

Wrong! When we tighten our belts, it means that we are trying to build up our savings. We do this by spending less. But spending drives our economy. Sales create jobs. So unless Obama has a secret plan to reverse three decades of current account deficits, the Government needs to loosen its belt when we tighten ours. If it doesn’t, then millions of us will lose our shirts.

** An aside: I am aware that I have said nothing about the usefulness of the spending projects, the waste and inefficiency that exists with many government programs, cronyism, inequality, etc., etc. These are legitimate and important questions, but they are not the focus of this analysis. I wrote this series of blogs to try to get people to understand the interplay between the private, public and foreign sectors’ balance sheets. Criticizing me for not addressing a myriad of other issues is like reading Old Yeller and complaining, “What about the cat? You’ve completely ignored the genus Felis!”

4 Trust Funds, 3 Problems: Why is the Other one so “Healthy”?

By Stephanie Kelton

Every year, the Trustees of Social Security and Medicare issue an annual report that examines the financial status of the various “trust funds” that purportedly sustain these vital programs. Social Security’s (OASI) and (DI) Trust Funds, as well as Medicare’s (HI) Trust Fund all face chronic problems, some in the not-too-distant future.  In contrast, Medicare’s (SMI) Trust Fund always receives a clean bill of health. Why is that?

The answer is so simple it apparently escapes notice, but here it is, straight from the annual report:

The Hospital Insurance (HI) Trust Fund is expected to remain solvent until 2029. The Disability Insurance (DI) fund is projected to become exhausted in 2018. And the Old-Age and Survivors Insurance (OASI) Trust Fund is considered adequately financed until 2040.  In contrast:

Part B of Supplemental Medical Insurance (SMI), which pays for doctors’ bills and other outpatient expenses, and Part D, which pays for access to prescription drug coverage, are both projected to remain adequately financed into the indefinite future because current law automatically provides financing each year to meet the next year’s expected costs.

In other words, it is sustainable — INDEFINITELY — because the government is committed to making the payments. Indefinitely.

And, as we have argued many times on this site (and elsewhere), the same commitment can easily be made to sustain Social Security (OASI and DI) and Medicare (HI) in their current form.  There is no economic justification for cuts to either program.  The decision is entirely political.

The American people must realize this before it is too late.

The CBO’s Misplaced Fear of a Looming Fiscal Crisis

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.

  1. “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).

  1. “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).

  1. “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.

  1. “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.

  1. “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.

  1. “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…

Why Dean Baker has Gone off the Rails on Social Security

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.

A Plea to the President: Tear Up That Speech

By Stephanie Kelton

My colleague and fellow blogger, Randy Wray, has just argued that President Obama should scrap the speech he’s planning to deliver tonight and surprise the American people with something entirely different. I couldn’t agree more. And while I agree that job creation must be JOB ONE in the months (and years) ahead, I would encourage the President to make massive tax relief the cornerstone of tonight’s speech.
Specifically, the President should call on Congress to support a full and immediate payroll tax holiday. Right now, the government takes away about 15% of our incomes in the form of payroll taxes. With a full payroll tax holiday, a married couple earning $60,000 a year would see their take-home pay increase by about $750 each month. In the aggregate, this will help millions of Americans pay their mortgages, student loans, credit card bills, and so on, while at the same time reducing business expenses (remember that employers contribute to the payroll tax too). All told, a full payroll tax holiday would allow Americans to keep about $1 trillion this year.
So stand before us, Mr. President, and tell us that you want to stop taking this income away from us until we, as a nation, have clawed back every job that has been lost since the start of the recession. Tell us that you intend to take bold steps to protect jobs, keep families intact and provide relief for millions of American businesses. Tell us that you have done all you intend to do to help the banks and the automakers and that you will not accept a jobless recovery — that an increase in economic activity is meaningless without rising employment in good jobs.
And, most importantly, tell us that you refuse to adopt a timeline for cutting the deficit. Tell us that you will not take one dime of payroll taxes away from us until your Administration can declare “Mission Accomplished” on the job front.
Finally, tell the American people that anyone who opposes a payroll tax holiday wants to keep taking hundreds, perhaps thousands, of dollars from them every month. Then watch what happens in 2012.

Gift-Wrapping the White House for the GOP

by Stephanie Kelton

It looks like Christmas has come early for one of President Obama’s most vocal critics. Rush Limbaugh said he hoped the president would fail, and the GOP is doing everything it can to make sure he does. The party stands united in its opposition to a (much-needed) ramping up of the federal stimulus effort. And, at the moment, the president is playing right into their hands.

Sen. Jon Kyl, R-Ariz., has called the $787 billion stimulus effort a “flop,” adding:

“The reality is, it hasn’t helped yet. . . Only about 6.8 percent of the money has actually been spent. What I propose is, after you complete the contracts that are already committed, the things that are in the pipeline, stop it.”

In other words, he thinks the stimulus isn’t working because the government isn’t spending the money FAST enough. And, with the lion’s share of the spending about to kick in, he wants to scrap the entire effort, just to make sure it won’t work.

The only thing more disappointing than hoping the president – any president – will fail is actively working to keep millions of Americans unemployed in order to score political points in the coming election. But that’s exactly what’s happening, and the president may be painting himself into a losing corner.

President Obama has insisted that: (1) the stimulus is working as planned; (2) a second stimulus is not needed; and (3) he will cut the deficit in half by the end of his first term.

If he sticks to his guns, I believe he will dig his own political grave (not to mention prolonging the agony for millions of Americans). He cannot have it both ways. He cannot reverse the effects of the worst economic downturn since the Great Depression and do it on a shoestring.

That isn’t to imply that $787 billion is chump change, but it pales in comparison to the losses that have already been borne by homeowners, businesses and investors. As Dean Baker recently pointed out, annual consumption is down about $700 billion (due to the loss of roughly $16 trillion in real estate and stock market wealth). Add to that “a reduction in annual rates of construction of about $450 billion” and a decline of “approximately $200 billion” in demand due to losses in the non-residential sector, and Baker says we’re looking at an annual loss of about $1,350 billion. And we’re trying to offset it with $300 billion or so (the annual stimulus) in spending by the federal government! It’s like using an umbrella to stop an avalanche. It won’t work.

But it gets worse, because Baker’s figures don’t account for the void that has been created by state and local governments, where expenditures have fallen by more than $64 billion in the last two quarters alone. And, with virtually every state bracing for even bigger cuts next year, we could easily lose another $100 billion or so in fiscal 2010. Then, of course, there’s the multiplier, which has been hard at work, exacerbating the magnitude of these cuts and costing us untold trillions in lost GDP.

But the president seems convinced that $787 billion will do the trick – at least according to his definition of the trick. You see, the Obama administration has not set the bar very high, and this seems to be why the president believes the stimulus has “worked as intended.” As he explained, it “wasn’t designed to restore the economy to full health on its own, but to provide the boost necessary to stop the free fall.” And this is why even bad news – e.g. 565,000 people filing first time jobless claims – can be interpreted as an indication that the stimulus is working as intended. (Recall that this was the smallest number since January 2009.)

Indeed, the president’s top economic advisors have always been careful to use the words “create or save” when describing the objective of the stimulus plan. And this means that net job creation isn’t the goal. The economy can continue to lose jobs faster than it creates them, and the policy will be described as “working” because the stimulus money helped at least some workers keep their jobs.

So the stimulus may be working “as intended,” but I don’t think the president can rely on semantics to carry him to victory in 2012. If President Obama wants a second term, he must join the growing chorus of voices calling for another stimulus and press forward with an ambitious program to create jobs and halt the foreclosure crisis. I have outlined my twelve-step recovery program, and others on this blog have put forward similar ideas. A payroll tax holiday that cuts FICA contributions to zero will provide immediate relief to millions of working families and their employers, boosting take-home pay as well as business profits. An additional $1,000 per capita will help ease the on-going budget crisis so that states can avoid further cuts to education and social services. A job-guarantee program, modeled on the WPA, will provide useful work and retraining opportunities for the many Americans who will not find jobs even after the economy recovers. Investing in our nation’s infrastructure – roads, bridges, transmission lines, etc. – will address years of neglect and improve the safety and security of all Americans.

These are the kinds of tangibles the American people will think about when they decide for themselves whether the stimulus was a success. At the end of the day, President Obama must cut loose the deficit bogy and abandon any date-specific goal for cutting the deficit in half. It is his Achilles heel. Let the deficit (and the debt) go where it will. With a sufficiently flexible fiscal response, GDP will explode, tax receipts will pour in, and the dreaded debt-to-GDP ratio will drop like a rock.

A Twelve-Step Program for Economic Recovery

by Stephanie Kelton

  1. Admit that the real economy is powerless against a de-regulated and de-supervised financial system
  2. Recognize that the fiscal powers of the federal government can restore stability
  3. Ignore the debt-to-GDP ratio; allow it to drift to whatever value is consistent with an economic recovery and a return to high employment
  4. Enact a full payroll tax holiday by setting employer and employee FICA contributions to zero
  5. Provide $1,000 per resident to state governments to help them stabilize projected budget shortfalls
  6. Commit $2.5 trillion to restore our nation’s crumbling infrastructure and build a modern energy superhighway to facilitate expanded use of renewable energy, reduce greenhouse gas emissions and lessen our dependence on fossil fuels
  7. Downsize the financial system; reduce the size of banks to the point that they no longer pose systemic risk
  8. Ban the securitization of non-prime loans
  9. Determine the real worth of bank assets; instruct the U.S. Treasury to conduct a survey of the underlying loan tapes and require banks to aggressively mark-to-market
  10. Stabilize the housing market by creating a Home Owners’ Loan Corporation and bestow upon it a full range of powers, including renegotiation and rental-conversions, as deemed appropriate in each case
  11. Announce a job guarantee program (like the WPA) to provide employment and income to the millions of Americans who will not find jobs in the private sector even after the economy recovers
  12. Carry these messages to elected officials and urge them to practice these principles in all our affairs

‘Easy Money’ Didn’t Sink the Economy

By Stephanie Kelton

Brad DeLong, Mark Thoma and David Beckworth have spent the last few days debating the extent to which Alan Greenspan’s easy money stance (2001-2004) qualifies as a “significant policy mistake.” DeLong asks:

“Should Alan Greenspan have kept interest rates higher and triggered a much bigger recession with much higher unemployment back then in order to head off the growth of a housing bubble?”

As I see it, these are really two separate questions: (1) Did Greenspan’s easy money policy cause the bubble? (2) Should Greenspan have attempted to diffuse the bubble – with higher interest rates — once he identified it?

I wrestled with these precise questions in a presentation I have given many times since last fall. I started with Greenspan’s own argument.

In an interview with a reporter from the Wall Street Journal, Greenspan characterized himself as “an old 19th-century liberal who is uncomfortable with low interest rates.” Yet he lowered the federal funds rate thirteen times from 2001-2003, pushing it to just 1% at the end of the easing cycle. Looking back on that period, Greenspan admits that his “inner soul didn’t feel comfortable” with those sustained rate cuts, but he maintains that it was the right policy in the aftermath of the dot.com bubble. Moreover, he insists that the run-up in housing prices was not the result of his monetary easing and that “no sensible policy . . . could have prevented the housing bubble.” Indeed, Greenspan maintains that the housing bubble emerged because risk premiums – not interest rates – were kept too low for too long.

As Greenspan argued in his memoir, geopolitical forces outside the control of the Fed caused risk premiums to decline, and this, ultimately, led to the housing bubble. In his view, there was nothing the Fed could have done to prevent the decline in risk premiums, which had its roots “in the aftermath of the Cold War.” His argument runs as follows: Over the past quarter century, the fall of the Berlin Wall, the collapse of the Soviet Union, China’s protection of foreigner’s property rights, the adoption of export-led growth models by the Asian Tigers, and the reinstatement of free trade produced significant productivity growth in much of the developing world. And because developing nations save more than developed nations – in part due to weaker social safety nets – there has been a shift in the share of world GDP from low-saving developed nations to higher-saving developing countries. Greenspan believes that this resulted in excessive savings worldwide (as saving growth greatly exceeded planned investment) and placed significant downward pressure on global interest rates. Thus, as he sees it, the demise of central planning ushered in an era of competitive pressures that reduced labor compensation and lowered inflation expectations. As a result, the global economy experienced years of unprecedented growth, markets became euphoric, and risk became underpriced.

This takes me back to Mark Thoma’s argument. Thoma believes that Greenspan’s easy money policy was a significant policy mistake. He said:

“It seems, then, the Fed did push its policy rate below the natural rate and in the process created a huge Wicksellian-type disequilibria.”

But Greenspan seems to be arguing that the natural rate was also declining, so it isn’t clear that market rates were pushed too low. And while I don’t buy Greenspan’s argument, I also don’t believe easy money sunk the economy.

I think there is an alternative explanation that is based on factors that had little (if anything) to do with Greenspan’s monetary easing from 2001-2003 or with geopolitical factors. To be sure, this sustained period of low interest rates made home ownership more affordable and increased the demand for home loans. But the increase in home prices could not have expanded at such a frenzied pace in the absence of rating agencies, mortgage insurance companies and appraisers who validated the process at each step.

As my colleague Jan Kregel put it, “the current crisis has little to do with the mortgage market (or subprime mortgages per se), but rather with the basic structure of a financial system that overestimates creditworthiness and underprices risk.” Like Greenspan, Kregel views the housing bubble and ensuing credit crisis as the inevitable consequence of sustaining risk premiums at too low a level. Unlike Greenspan, however, he maintains that bubbles and crises are an inherent feature of the “originate and distribute” model. Under the current model, risks become discounted because “those who bear the risk are no longer responsible for evaluating the creditworthiness of borrowers.”

Thus, with respect to the debate over the role of low interest rates, I would argue that it was not loose monetary policy but loose lending standards (abetted by a hefty dose of control fraud) that brought us to where we are today.

Now to the second question: Should Greenspan have raised rates sooner, in order to “head off the bubble”?

DeLong has admitted to being “genuinely not sure which side I come down on in this debate.” Unlike Thoma, DeLong appears sympathetic, even empathetic, trying to imagine what it must have been like to be in Alan Greenspan’s shoes:

“If we push interest rates up, Alan Greenspan thought, millions of extra Americans will be unemployed and without incomes to no benefit . . . . If we allow interest rates to fall, Alan Greenspan thought, these extra workers will be employed building houses and making things to sell to all the people whose incomes come from the construction sector . . . . If a bubble does develop, Greenspan thought, then will be the time to deal with that.”

But Alan Greenspan was never so clear-headed in his thinking. Indeed, like DeLong, Greenspan appears to have been genuinely conflicted. He has argued that it is virtually impossible to spot an emerging bubble:

“The stock market as best I can judge is high; it’s not that there is a bubble in there; I am not sure we would know a bubble if we saw it, at least in advance.” (FOMC transcripts, May 1996)

Then, just four months later, Greenspan indicated that he could not only spot an emerging bubble but that it would be dangerous to ignore it:

“Everyone enjoys an economic party, but the long term costs of a bubble to the economy and society are potentially great. As in the U.S. in the late 1920s and Japan in the late 1980s, the case for a central bank to ultimately to burst that bubble becomes overwhelming. I think that it is far better that we do so while the bubble still resembles surface froth, and before the bubble caries to the economy to stratospheric heights. Whenever we do it, it is going to be painful, however.” (FOMC transcripts, September 1996)

In 2004, Greenspan spoke before the American Economics Association and took the position that it is dangerous to address a bubble, insisting that it is preferable to let the bubble burst on its own and then lower interest rates to help the economy recover:

“Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion”.

Since then, Greenspan has argued that the Fed actually was trying to address the emerging housing bubble when it began to raise rates in the mid-2000s, but he says the policy was unsuccessful because long-term rates remained stubbornly low. Of course, he also said:

“I don’t remember a case when the process by which the decision making at the Federal Reserve failed.”

And I think we can all agree to disagree on that point.

Why The Stimulus Isn’t Working

by Stephanie Kelton

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Congressional Budget Office’s long-term budget outlook

by Felipe Rezende and Stephanie Kelton

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

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

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

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

Private Sector Surplus = Public Sector Deficit + Current Account Surplus

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

Source: Levy Institute

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

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

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