Monday, October 29, 2012

Austerity is no answer!

The Peter G Peterson Foundation, in a futile attempt to reduce federal deficits, is investing in a big program to promote austerity, which demands reduced federal government spending. Unfortunately, the program has a high probability of being implemented, because many pundits, politicians, and a few economists seem to like the idea.

Austerity deprives the private sector of dollars, which reduces household demand for products, which, in turn, reduces the incentive of private industry to invest. This fatal attraction to austerity during recovery from a depression has afflicted the euro zone and the misdirected economies of Britain, Australia, and Japan. We don’t have to repeat those mistakes, and we must not.

The allure of austerity comes from the old, gold-standard view of money. In this old view, before government can spend, it must first acquire money from the private sector through taxation or borrowing.

From this gold-standard regime came the present-day myths, "Government must balance its budget just like a household," “national debt is a burden on our grandchildren,” and “international bond markets will not want to buy our debt.”

The new way money operates in our economy began when we went off the gold standard, which was finalized with the demise of the Bretton Woods Agreement in 1973. The modern US dollar is fiat money with a floating, foreign exchange rate. As a consequence the real value of the dollar depends not on the arbitrary value of a metal dug out of the ground but on our nation's productive output. That is something that can neither be taken from us nor given to us. It depends on our own hard work and stewardship of our economy. 

Dig money from the ground? Better to use the effort to build a school or bridge.

The modern dollar changes everything. A sovereign country that issues its own fiat money with a floating exchange has no economic reason to tax or borrow from the private sector to acquire money. Instead, government creates the dollars necessary to purchase goods and services from the private sector. These purchases put dollars into the private sector by the amount of government spending minus tax revenue. Yes, deficit spending increases the financial assets of the private sector exactly to the dollar of the deficit. This, of course, raises the question of why we tax at all.

Taxation creates demand for money issued by the government, takes dollars out of the private sector to avoid inflation, and provides a means of wealth redistribution from the rich to the poor.

In what is called borrowing, government sells Treasury bonds to provide a means for risk-free preservation of private financial assets and a way for the government to balance reserves in the banking system. Banks gladly use their reserves to buy bonds, which provide greater interest. The process is just like a household taking money from a checking account to buy a Certificate of Deposit.

Our US economy, measured by gross domestic product (GDP), depends on the sum of household consumption, business investment, government spending, and net exports. As we are a net importer, net exports is a negative number. So, consumption and investment must usually carry the load, but each depends on household willingness to go buy things. Business will not invest more in the means of production unless there is consumer demand for things, and households will not buy things unless they have money to spend.

Contrary to common assertions, in the absence of household willingness to buy things, no amount of lower taxes or reduced regulations will induce business to invest. Household demand drives GDP.

In an economic downturn, such as we have experienced since 2008, when consumers are cautious about spending and business investment is waiting for customers to return, fiat money provides a solution.

The federal government can deficit spend to maintain GDP and increase employment by investing in the future. Such investment might include infrastructure (transportation, utilities, and education), new means of energy production, and scientific research and development. The government can never spend too much money as long as there are unemployed people and equipment that can be put into  production.

Those who promote austerity assert that federal deficits will increase interest rates and burden our grandchildren with increased national debt. They are wrong.

Interest rates are set, not by the “market,” but by the central bank in any sovereign country with floating-rate, fiat money. Our grandchildren will inherit both the interest-bearing bonds that constitute the so-called "national debt," and the means of production embedded in a modern infrastructure. 

Austerity reduces GDP, increases unemployment benefit costs, and increases the deficit by reducing employment of our productive resources. We should not keep any resources on the sidelines; we need to keep them all working and producing.

Related Reading:
Pete Peterson Has Won
Lerner on “The Burden of the National Debt”
Unemployment is a misallocation of resources

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