If Balanced Budget Amendment Sounds Good - Think Again

The US House of Representatives led by Majority Leader Eric Cantor will soon vote on a Constitutional Amendment to assure balanced federal budgets. The objective is to ban government outlays in excess of taxes unless approved by a super majority in both the House and the Senate.

This sounds good to people who don’t understand how money and the government work. In fact, it would just give more tools to those who would finesse money from the poor and give it to the rich.

Federal government and households differ in that the government can create money. Households must earn money or borrow it. The government creates money by purchasing goods and services from the private sector. Then the government taxes to get some money back. Spending more than tax revenue is deficit spending by definition and spending less results in surplus. 

Likewise, a private sector deficit occurs when private spending exceeds earnings, and the private sector saves when it spends less than it earns. The private sector net saves or borrows.

With those simple definitions in mind we can follow dollars and ignore the foreign sector (exports and imports) for simplicity. If a dollar goes out of the government sector, it goes into the private sector and vise versa. It follows that when a government is in deficit it is, by definition, putting money into the private sector that can be saved or used to consume. 

Also, when the government is in surplus, money flows out of private sector savings to the government. In extreme cases of government surpluses or low deficits the private sector may be driven into debt. The recent housing crisis is an all too recent example. And, when money flows out of the private sector, from whose pocket does it flow? Hint: Not the ruling class.

The conclusion is that a balanced budget amendment will prevent both the economy from growing and the private sector from saving.

Some might assert that the money created and spent into the private sector just ends up as Treasury securities so no net money is produced. That would be incorrect, because the Treasuries are the result of bank reserves at the Fed being converted from demand accounts to longer term interest-bearing Treasuries. The recipients of deficit dollars are still richer.

Others may say that money is created through bank lending. That would be correct, because banks put money into circulation by making loans. However, that money is taken out of circulation as the loan is repaid. No net money is produced.

The common wisdom that deficits are bad and surpluses are good holds only for households, firms, and state governments. For the federal government, deficits are normal and necessary to keep the economy growing.

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The CBO Doesn’t Get It

On June 22, the Congressional Budget Office issued its 2011 Long-Term Budget Outlook.

The supposedly non-partisan CBO makes arguments that favor the politically correct deficit terrorists even though they are wrong. The role of the CBO is to make straight forward projections based on current or proposed law. Consequently the projections are prone to be as wrongheaded as the law. The CBO should stick to accounting and stay out of politics.

One can quibble with the CBO assumptions and calculations, but its reasoning and conclusions appear to come from a fiscally constrained paradigm like a gold standard. In the report Summary we have the following.

“In particular, large budget deficits and growing debt would reduce national saving, leading to higher interest rates, more borrowing from abroad, and less domestic investment—which in turn would lower income growth in the United States.” 

Students of modern money operations could not disagree more with this statement. We know that “national saving” has no meaning for a country that creates its own sovereign currency as it needs it. Growing debt in itself cannot lead to higher interest rates, because the Fed sets those rates not the global market. More borrowing from abroad is optional, and domestic investment would be increased as federal spending puts dollars into the private sector.

We could stop here, but there is more to chew on. In the full report we find the following.

“Increased government borrowing generally draws money away from (crowds out) private investment in productive capital, leading to a smaller stock of capital and lower output in the long run than would otherwise be the case. Deficits generally have that effect on private investment because the portion of people’s savings used to buy government securities is not available to finance private investment.”

This statement might be true in an economy with a fixed amount of currency, that is, a financially constrained system where the private and government sectors compete for the existing dollars and bid up interest rates. 

In the modern view, government does not “crowd out” private investment because the money supply expands through the banking system according to demand. Consequently, there is ample capital available. Further, deficits put money into the private sector, so there are more funds for private investment. It is government surpluses that take funds out of the private sector not deficits.

The negative consequences of rising levels of debt according to the CBO are:

• “Higher levels of debt imply higher interest payments on that debt, which would eventually require either higher taxes or a reduction in government benefits and services.
• Rising debt would increasingly restrict policymakers' ability to use tax and spending policies to respond to unexpected challenges, such as economic downturns or financial crises. As a result, the effects of such developments on the economy and people's well-being could be worse.
• Growing debt also would 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. Such a crisis would confront policymakers with extremely difficult choices. To restore investors' confidence, policymakers would probably need to enact spending cuts or tax increases more drastic and painful than those that would have been necessary had the adjustments come sooner.”

These consequences are wild speculation and contrary to observed fact. 

Japan, which also has a sovereign, fiscally unconstrained money system, has experienced high deficit and debt ratios, vastly higher than foreseen by the CBO, for many years while maintaining low interest rates. 

With a sovereign currency, we have unlimited ability to use tax and spending policies to respond to unexpected challenges.

Lastly, there can be no sudden crisis that screws our ability to borrow at affordable rates, because we do not need bond sales to fund our deficit. The government just borrows back its own spending to meet it target interest rate. It is merely conversion of funds in reserve checking accounts at the Fed to interest bearing accounts.

“Bonds? We don’t need no stinkin’ bonds!” In fact, they are a voluntary holdover from the gold standard, when we did need them.

The CBO is only politically correct when it concludes that the US government “will need to increase revenues substantially as a percentage of GDP, decrease spending significantly from projected levels, or adopt some combination of those two approaches.” We would prefer that “in the long-term” be substituted for substantially and significantly.

We would conclude just the opposite. The government should reduce taxes and/or increase spending at the present time to accelerate demand during a demand-deficient recession.

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Private and Government Finances are Not the Same

Many people accept without question that federal and private budgets should be thought about in the same terms. Republican leadership has compared federal deficits to household deficits, and have alluded to the specter of bankruptcy. President Obama has said that the country is running out of money and that like households, the government must tighten its belt. Nothing could be farther from the truth.

Below, we make some comparisons between federal and private finances that make us wonder why anyone would think they should be the same. 

Objectives

Private entities seek to profit by providing goods and services to buyers. 

Government does not seek to profit, but tries to provide a secure, fair, healthy, and just environment in which its citizens can prosper.

Issuer vs User

Private entities are users of dollars, earned or borrowed, to enable spending on goods and services.

Government is the issuer of dollars that it creates in the process of spending to purchase goods and services from the private sector.


Currency as IOUs

Private entities can borrow up to creditable limits, but they cannot force anyone to accept their IOUs.

Sovereign currency represents government IOUs that are binding as legal tender.

Insolvency

Private entities become insolvent when their debts exceed their ability to pay them off, which leads to undesirable consequences.

Government is never insolvent; with a sovereign, floating exchange rate currency it can always meet any debt obligation denominated in its own currency.


Operations

Private entities earn, save, and invest.

Government spends, taxes, and makes policy to steer the economy toward full employment and stable prices.

Gold Standard

It is apparent that government finances are completely unlike, even the opposite of, private finances. Under the gold standard, which was abandoned for good reasons in 1971, government and private finances were similar. 

United States Gold Certificate
Fifty Dollars In Gold Coin
Payable To The Bearer On Demand

As people, even our President, regard private and government finances as comparable, it reminds us that the transition has not yet been made from the old, convertible, fixed-exchange rate Gold Certificates to the modern, non-convertible, variable exchange rate, Federal Reserve Notes.

One of the disadvantages of the gold standard was countries that consistently ran foreign exchange deficits, as we do, were unable to stimulate their economies to compete with other countries. They were literally losing money to those countries. Our country is behaving as if we were constrained in the same way we would be under a gold standard. It's killing our future!

Related Reading:

The Case Against Intergenerational Accounting:

Gold standard and fixed exchange rates

Edited 06/27/2011 to make it easier to read.

Private Saving Increases the Deficit

In a recent post, we derived the Financial Sector Balance equation by equating two equivalent expressions for GDP. The equation relates the financial balance among the domestic government, domestic private, and foreign sectors; and it is written simply as 

1) (S - I) + (T - G) = (X - M),

where the difference between private saving S and private investment I, is net private saving (S - I); the difference between government taxes T and government spending G, is net government spending (T - G); and the difference between exports X and imports M, is net exports (X - M).

In English, Equation 1) reads; net private saving plus net government spending is equal to net exports. This is an accounting identity that holds after the fact, ex post, regardless of the economic system or political ideology. The equation does not prove causality; it just balances the books as was verified in the earlier post.

Some economists rearrange Equation 1) to get 

2) I = S + (T - G) - (X - M), 

which in English reads; private investment or “national savings,” I is the sum of private saving and public saving minus net exports. It is used before the fact, ex ante, as a policy guide, and it advises reduced personal spending (net saving), budget surplus, and reduced exports. 

The idea is that savings enable investment just like it does for a household or business. When this austerity solution, which works for a household, is applied to the whole economy, we run into the Paradox of Thrift. When everyone avoids spending it drags down the whole economy.

Equation 2) is valid only for a fixed exchange rate and fixed money supply as with a gold standard. It is another example of irrelevant gold-standard thinking that gets things backwards. 

The concept of saving for a government that issues a sovereign, floating rate currency makes no sense. It serves no purpose for government to stockpile money that can be created at will. The money supply is neither constant nor knowable. It increases through deficit spending and bank loans and decreases through taxation and loan payoff as we discussed here.

Clearly, private net saving, in Equation 1), is closely connected to the government spending balance. When (S - I) is positive, the private sector is accumulating savings; when negative the sector is net borrowing - going more into debt. 

Continuing with Equation 1), we know that now and for years to come imports will be greater than exports so (X - M) will be negative. It follows that, if (S - I) is to be positive, which is generally good, (T - G) must be negative, which means deficit spending.

For example, if (X - M) = -2, and (S - I) = +2, then (drum roll, please) (T - G) = -4, it can be no other way.

Our government does a lot to promote saving as we have tax-advantaged saving programs including IRAs, 401-Ks, 403-Bs and others. The economy will try to accommodate private sector saving decisions by incurring budget deficits. Those deficits have to be large enough to include the foreign trade deficit. That is to say, private decisions to save and foreign trade deficits drive the government spending balance into deficit.

Efforts to reduce deficit spending will just make things worse unless the government promotes a big program to entice people to take on debt. Alas, we have already tried that; it resulted in the housing crisis.

The popular notion that budget deficits are bad and surpluses are good works for households; for the federal budget it is exactly wrong! 




Thanks to Duane for comments.