The Deficit Myth

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Stephanie Kelton. The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy. New York: Hachette Book Group, 2020.

How many of these statements do you agree with?

  • The federal government should budget like a household.
  • Deficits are evidence of overspending.
  • One way or another, we’re all on the hook [for the national debt].
  • Government deficits crowd out private investment, making us poorer.
  • The trade deficit means America is losing.
  • “Entitlement” programs like Social Security and Medicare are financially unsustainable. We can’t afford them anymore.

According to economist Stephanie Kelton, none of these statements is true. Together they create a “narrative of scarcity” that puts unnecessary restrictions on our government’s ability to build a “people’s economy” that works for all of us. What is especially disappointing is that politicians invoke this narrative selectivity, using it mainly to cast doubt on the affordability of programs like Social Security or universal health insurance. “Somehow, there’s always money for war and tax cuts. For just about everything else, however, lawmakers are expected to show that they can ‘pay for’ their spending. At least on paper.”

Kelton wants to replace this narrative with what she calls a “narrative of opportunity.” She challenges us to think outside the box about government’s role in the economy, and does it with simple and cogent arguments. (She credits her editor with saving her from herself, resisting the temptation to fill her book with formulas and charts.) Kelton is a leader in the school of Modern Monetary Economics (MMT). Her arguments should appeal to progressives, but not to free-market conservatives who want to minimize government’s role in the economy, or to cynics who have lost faith in democratic government’s capacity to work for the general good.

Here I will examine the first three of her six economic myths.

Myth #1: The federal government should budget like a household

I have often written that living within one’s means is the first rule of personal finance. Spend less than your income, and your savings will build wealth. Spend more than your income, and you will run up debt and see your net worth deteriorate. And you’re not allowed to paper over the difference by printing money in your basement!

Conventional wisdom applies the same reasoning to government. As President Obama said in his 2010 State of the Union Address, “Families across the country are tightening their belts and making tough decisions. The federal government should do the same.” The argument of this book rests on the idea that the federal government is not the same, and does not have to adopt the same kind of frugality. “Unlike a household, the federal government issues the currency it spends.” That difference applies to countries with monetary sovereignty, “where the government is the monopoly issuer of a fiat currency.” That has been the fact ever since the United States left the gold standard in 1971, but most citizens and policymakers have yet to grasp its full implications and possibilities.

Governments without monetary sovereignty have to follow the rule Kelton summarizes as (TAB)S, shorthand for the requirement that taxing and borrowing must come before spending. But the federal government can follow the rule S(TAB), where spending can be somewhat independent of taxing and borrowing. Government does not have to take a dollar out of the economy for every dollar it puts into it by spending, and it usually doesn’t. The country’s money supply does not consist of a fixed number of physical dollars, backed by a supply of gold or any other commodity. When the government makes a major purchase, such as military hardware from Lockheed:

…the US Treasury instructs its bank, the Federal Reserve, to carry out the payment on its behalf. The Fed does this by marking up the numbers in Lockheed’s bank account. Congress doesn’t need to “find the money” to spend it. It needs to find the votes! Once it has the votes, it can authorize the spending. The rest is just accounting. As the checks go out, the Federal Reserve clears the payments by crediting the sellers’ account with the appropriate number of digital dollars, known as bank reserves.

It’s the digital equivalent of printing money in your basement, with the important qualification that it’s perfectly legal and ordinary.

The need to balance such spending with revenue is not absolute, and it’s only one of the reasons for taxation. If the government puts much more money into the economy by spending than it takes out by taxing, that can be inflationary, as discussed in the next section. But government has other reasons to tax, such as redistributing income to those who need it and modifying behavior with tax penalties and credits.

Similarly, the government sells treasury bonds not just because it must borrow to cover deficits, but to reward people for saving and investing, in this case investing in their government. That helps to insure that savers can invest safely and with a reasonable rate of return. As I’ll explain more later, it also helps keep interest rates from falling below the Federal Reserve’s target for purposes of controlling inflation.

Kelton is not saying that government can engage in unlimited spending. Instead, she is asking us to think differently about what the real limit on spending is. Strictly speaking, it is not the revenue collected or some balanced budget requirement. Historically, deficits have actually been better for the economy than budget surpluses, which have always been followed by economic recessions. So how do we draw the line between responsible and irresponsible spending?

MMT redefines what it means to engage in fiscally responsible budgeting….“It’s the economy’s real resources, stupid!” We are a nation rich with real resources—advanced technologies, an educated workforce, factories, machines, fertile soil, and an abundance of natural resources.

Instead of balancing spending with revenue, government’s more important task is to balance it with the productive resources of the economy.

Myth #2: Deficits are evidence of overspending

Instead, MMT says that the actual evidence of overspending is inflation, which deficit spending may or may not create.

If inflation is a condition of too much money chasing too few goods and services, that suggests two logical ways of fighting it. The first is to restrict the money government puts into the economy, so it won’t outrun economic growth. That calls for fiscal and monetary restraint, with controls on deficit spending and high interest rates to discourage borrowing. The alternative is to expand the real economy to keep it growing along with the money supply. That calls for government spending that increases the production of goods and services.

Kelton believes that federal policy has relied far too much on austerity to fight inflation, and far too little on growing the real economy. She feels that Obama’s fiscal conservatism and the Fed’s premature hikes in interest rates slowed the recovery from the Great Recession. (The Fed began raising interest rates when unemployment was still around 5%, but inflation was under 2%).

Kelton also believes that economists have been too tolerant of unemployment, believing that low inflation requires a relatively high “natural rate of unemployment.” They often attribute high unemployment to a mismatch between job requirements and job skills in a rapidly changing economy. Kelton wants to lay the blame more heavily on misguided inflation-fighting policies themselves. She says that “the majority of economists remain wedded to a fifty-year-old doctrine that relies on human suffering to fight inflation.” Instead, she wants to have a federal job guarantee that spends what it takes to put people to work doing useful things. Again, the government can put in more money than it takes out in taxes as long as the spending actually increases real output.

This argument got me thinking about what it is government actually does and how we account for it. The standard formula for GDP distinguishes private investment (I) from private consumption (C), but lumps together all public spending (G). If we think of government as a big consumer, then deficit spending adds to economic demand while neither adding to supply nor curtailing the demand from other consumers through taxation. That can stimulate aggregate demand when the economy is operating at less than full capacity, but becomes inflationary as the economy heats up. But if we think of government as an investor in the country’s productive capacity, some forms of spending add both to demand (by providing income people can spend) and to supply (by building some form of capital). Spending on infrastructure adds to the country’s physical capital, and spending on health and education adds to the country’s human capital. That’s the kind of spending that is most likely to be good for the economy even if it is not “paid for” with higher taxes. I think that Kelton could have helped her case by distinguishing different kinds of government spending more clearly.

Although Kelton wrote this book before President Biden took office, these points are directly relevant to the debate over his budget proposals. His plan for “human infrastructure” faces serious opposition, both from some Democrats who fear it won’t be paid for, and Republicans who fear that it will be paid for—with tax increases. If Kelton is right, both fears are overblown, since the plan sounds like just the kind of spending most likely to increase employment without inflation, whether the spending is balanced by higher taxes or not.

Myth #3: One way or another, we’re all on the hook

According to conventional wisdom, each taxpayer owes a share of the national debt, so as it goes up our individual net worth goes down. Kelton asserts to the contrary, “The national debt poses no financial burden whatsoever.” How can that be?

If you have a retirement plan or other investments, you may own shares in a corporate bond fund. A corporate bond is a liability for the corporation that issues it, but it’s an asset for you. Such debt is an ordinary feature of capitalism, and it only becomes a problem when a company’s debt burden becomes so great that it defaults on its obligations.

Similarly, the national debt is a liability of the federal government, but it is an asset for owners of treasury bonds. And it is an especially safe asset, since the federal government has never defaulted on a financial obligation and has no reason to do so. A government with monetary sovereignty cannot go broke. It can pay off its debts anytime it likes by replacing bonds with cash it creates. Instead, it chooses to offer people an interest-earning opportunity if they are willing to invest in the government. “There’s nothing inherently dangerous about offering a safe, interest-bearing way for people to hold on to dollars.”

West 43rd Street in New York City has a large clock that displays the national debt as it accumulates. We could just as well call it a savings clock, except that we fail to grasp that in this case, “good old” savings is the flip side of “bad old” debt.

What about the future? Don’t the taxpayers have to pay off the debt to the holders of treasury bonds someday? No. The government is obligated to pay the interest, but it can roll over the principal indefinitely. Even at very low interest rates, treasury bonds always seem to have lots of willing buyers. And if the interest payments were to become a burden, the government could create the money to pay off some or all of the debt. Traditional monetarists would expect that to be inflationary, but MMT economists disagree. Eric Lonergan points out that trading cash for bonds would have no effect on the public’s net wealth. Bondholders were choosing to save their money, and they could still save their money by putting it in some other form of savings. Only if they ran out and spent the cash would they create a situation of too much money chasing the same goods and services. But if that’s what they want to do, there’s nothing stopping them from cashing in their bonds now. Taxpayers needn’t fear that spending to address national needs will force the government to take on too much debt and then make the taxpayers use their limited dollars to pay it off.

The next post will deal with three other myths Kelton tries to dispel.


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