The Deficit Myth (part 2)

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Myth #4: Government deficits crowd out private investment, making us poorer

The logic of this familiar argument goes like this: The country has a limited supply of “loanable funds,” money that people are willing and able to save and invest. When government has to borrow in order to finance a budget deficit, that puts it in competition with private firms for loanable funds and raises interest rates. That discourages private investment and damages the long-run growth of the economy.

Kelton says that the historical evidence does not support this argument. She quotes Timothy Sharpe, who found that “the empirical evidence reveals crowding-out effects in nonsovereign economies, but not within sovereign economies.” The difference, consistent with Kelton’s general argument, is that sovereign economies influence the supply of loanable funds by their power to create money. This myth is another example of thinking the wrong way around, putting borrowing first—as in (TAB)S—instead of spending first—as in S(TAB). With spending first, “the government’s own deficit supplies the dollars that are needed to purchase the bonds” (emphasis in original). The demand for dollars to borrow goes up, but so does the supply.

Although the historical experience does not support the claim that government borrowing leads to investment-crushing interest rates, Modern Monetary Theory does make the case that borrowing keeps rates from going too low. If the government were to put too many dollars into the economy without borrowing some of them back, that could produce a surplus of loanable funds and very low interest rates, which in turn would trigger inflation by encouraging too much private borrowing and spending. “From an MMT perspective, the purpose of selling bonds is not to ‘finance’ government expenditures (which have already taken place) but to prevent a larger infusion of reserves from pushing the overnight interest rate below the Fed’s target level” [for controlling inflation].

The public and private sectors of the economy work in tandem. Kelton calls them buckets. For every deficit in one sector, the other sector has a corresponding surplus, and vice versa. (A third bucket, the foreign sector, is discussed in the next section.) This helps explain why government budget surpluses tend to contract the economy. When the federal budget is in surplus, the government is taking out more dollars in taxes than it is giving back in spending. But that means the private sector is in deficit, giving up more dollars to government than it receives through government spending. That means, “It’s fiscal surpluses, not fiscal deficits, that eat up our financial savings” and reduce our capacity to invest for the future.

On the other hand, the combination of public deficit/private surplus has the potential to help grow the economy. How much it will, however, depends on how productively the surplus is used. What has been disappointing about the recent economy is the sluggish growth despite the large deficits. The Trump tax cuts were another big gift to the private sector, but the benefits went mostly to the wealthy. From this perspective, what the country needs to do is not put an end to deficit spending, but use it to invest in more of what most people need.

Deficits can be used for good or evil. They can enrich a small segment of the population, lifting the yachts of the rich and powerful to new heights, while leaving millions behind. They can fund unjust wars that destabilize the world and cost millions their lives. Or they can be used to sustain life and build a more just economy that works for the many and not just the few.

Myth #5: The trade deficit means America is losing

Here Kelton introduces the third bucket in MMT accounting, the foreign sector. It includes all the other countries with which we trade. Now all three sectors must be in balance. The total of any dollar surpluses must equal the total of any deficits. For purposes of understanding that balancing act, the US trade deficit is actually a foreign sector surplus. “America’s trade deficit arises from the rest of the world’s desire to accumulate a surplus of US currency.” People in many countries are happy to hold US dollars in reserve, rather than convert them to some other currency. They like having dollars available either to buy American goods or to invest in what is still one of the strongest economies on the planet. That includes investing in bonds that are backed by the full faith and credit of the US government.

In return for our dollars, we get “stuff”—a lot of material things that other countries can make better—or at least more cheaply—than we do. Up to a point, global trade is a win-win, not a loss at all.

However, since the trade deficit represents a foreign surplus, it must be balanced by some kind of domestic deficit, either in the private sector or the public sector, or both. We don’t want more dollars flowing out of the private sector than coming in, because that means fewer dollars to spend or invest in our own economy. The only logical alternative is for the federal government to spend more than it taxes. As long as we have a trade deficit, “only Uncle Sam can supply enough dollars to keep the private sector in surplus. To do that, the government must run budget deficits that exceed the US trade deficit.”

That conclusion reinforces the conclusion of the previous section that government deficits create private-sector surpluses. But not all government deficits are equally conducive to a strong economy. Think of all the ways that government can run a deficit—cutting taxes, increasing transfer payments like unemployment compensation, buying more weapons, spending more on health care, and so forth. Why not use deficit spending to address what most concerns Americans about the trade deficit—loss of American jobs? (Not to say that free trade is the only reason for losing them. Automation is reducing the demand for labor in many industries, and will do so even more in the future.) Kelton wants to shift from a policy that tolerates joblessness for the sake of austerity and low inflation, to one that guarantees a federal job to any unemployed person who wants to work. Whether that is inflationary would depend on how productively the additional workers are employed. The goal would not be to pay people for pointless busywork, but to get them doing publicly useful work that the private sector is not getting done. “With decent jobs guaranteed for all, workers can engage in a public-led industrial policy aimed at producing sustainable infrastructure and a wider array of public services.” More on that in the next post.

Kelton is very critical of the recent policies for dealing with globalization. We have run federal deficits that pump dollars into the private sector. But we have increased deficits not so much with useful public investments as with tax cuts that primarily benefit the wealthy. We hold wages down in the mistaken belief that cheap labor—as opposed to smarter labor—is the only way to compete globally. We punish Americans for buying foreign products by taxing them with tariffs.

The Trumpian approach to trade creates strife and a zero-sum race to the bottom over too few globally available jobs. Already, President Trump’s tariffs have failed to revive American manufacturing, raised prices for US consumers, invited retaliation from China, and contributed to a slowdown in the global economy. All in subservience to the trade deficit myth.

Kelton refuses to believe that we have to accept slow growth, wage stagnation, and tariffs as the price for living in a global economy. Instead, we can combine the government’s ability to create dollars with the unrealized potential of our workforce. We have nothing to fear from global trade, as long as we do a better job of creating qualified workers and good jobs at home. Government spending on human capital development and a federal job guarantee can lead the way.

This chapter also puts American complaints about globalization in perspective by acknowledging the plight of the truly disadvantaged peoples of the global economy. They are the poorest developing countries, with nothing to export but cheap labor and raw materials—often a legacy of colonialism—but needing dollars to import other necessary goods. Their reliance on a few basic commodities makes their economies vulnerable to fluctuations in world prices, and their dependence on foreign capital puts them at the mercy of speculative investors, who often invest intermittently and selectively instead of contributing to longer-term, diversified development. International banking policies create additional problems for these countries, as when richer countries raise interest rates to fight inflation, increasing poorer countries’ debt burden; and when, as a condition of assistance, international agencies impose austerity measures that further increase unemployment and poverty. And we think the global economy is hard on us!

Myth #6: “Entitlement” programs like Social Security and Medicare are financially unsustainable

This myth is another consequence of thinking that all government spending must be paid for with taxes. Franklin Roosevelt set up the Social Security system that way by creating a new payroll tax to fund it. Current workers would pay in so that current retirees could draw out. As people started living longer, the ratio of retirees to workers increased, making that particular funding method harder to sustain. Making matters worse, recent generations of workers have also faced slower wage growth and loss of traditional pensions with guaranteed benefits.

What is really unsustainable here is not the idea that retirees should have a decent income, but the particular funding method the government has been required to use. Kelton makes that point very effectively by contrasting how the government’s own reports distinguish different entitlement programs:

Social Security’s programs and Medicare’s Hospital Insurance are considered fiscally unsustainable because the government isn’t committed to making payments, while Medicare Parts B and D get a clean bill of health because Congress has granted the legal authority to make the payments no matter what else happens.

Social Security could also have a clean bill of health by a simple change in the law committing the government to make their payments come what may. Federal Reserve Chairman Alan Greenspan acknowledged as much when Congressman Paul Ryan, an advocate for Social Security privatization, asked him to confirm that the system was in trouble:

Greenspan started by dismissing the entire premise behind Ryan’s question. “I wouldn’t say that the pay-as-you-go benefits are insecure,” he said, “in the sense that there’s nothing to prevent the federal government from creating as much money as it wants and paying it to somebody.

As usual, the point here is not that the government can spend whatever it likes. It is that the real limit on spending is the country’s ability to grow its resources and use them wisely, something that the government of a democratic society can influence. “We should stop asking the question, How will we pay for it?, and start asking, How will we resource it?” The price we pay if we do end up spending beyond our resources is inflation. But even that has the upside of spreading the pain around instead of singling out the elderly to bear the burden of our economic mistakes. (OK, that last point is mine, but I suspect that Kelton would agree.)

Here’s a good summary of the MMT perspective:

Our big challenge isn’t cost. It’s making sure that our economy is producing the right output mix over the coming decades. The problem isn’t a lack of bits and bytes on some electronic spreadsheet. The problem is a lack of vision. There are many ways to improve life for all of us, even in a world of limited resources, if we’re smart enough to imagine them and brave enough to try.


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