Sunday, June 26, 2011

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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