Wednesday, September 24, 2014

Federal Deficits are Necessary

 A 600-word version of this was submitted to the Santa Fe New Mexican in early September and this version to the Albuquerque Journal by Duane and I as co-authors. Figure was not submitted. Neither has been published. I suspect that the title/subject matter is too radical for editorial staffs. We will have to keep trying.

Our economy is struggling under high unemployment and slow growth because of widespread, irrational fear of deficits and public debt. Candidates for the upcoming election promise to increase austerity and repay the “national debt.” Even the White House is bragging about small and decreasing deficits. But, deficits are necessary, more so for a languishing economy. This discussion illuminates how federal deficits reduce unemployment and result in private savings.

Most of our money is created in the private sector by bank loans driven by business investment activity in response to consumer demand. Contrary to common understanding banks do not simply lend out deposits. A quote from a recent Bank of England report says it succinctly:

    “Whenever a bank makes a loan, it simultaneously creates a matching deposit in the
    borrower’s bank account, thereby creating new money.”

Because money created by bank loans must be repaid, there can be no net savings from loan activity. It is a zero-sum game in which prosperity is experienced only if loans are made faster than they are repaid. The domestic private sector deflates unless continually boosted by new loans.

The economic risk is that unrestrained bank credit can lead to unsustainable private debt, as in the recent housing bubble. Unable to service their debt, borrowers reduce consumption, which leads to unemployment as firms cut back production due to reduced consumer demand.

Private loans drive our economy, but when the economy falters, either the federal government must intervene or export trade must increase to restore employment and stabilize the economy.

Like bank loans the federal government creates new money when it makes deposits into bank accounts to pay for purchases from the private sector. Unlike bank loans there is no corresponding private liability created, and the deposit remains in the private sector unless removed by taxes. Federal spending increases both net private savings and consumer demand while taxation decreases them.

Exports to foreign nations can also provide income to our domestic private sector. However, the US has been a net importer since the 1970s. Consequently, our foreign trade deficits reduce our domestic financial assets and cause unemployment as jobs go overseas.

In good times businesses borrow to invest, consumers borrow to consume, and government tax revenue is high. But, if federal fiscal policies result in low deficits or surpluses while imports are high, financial assets decrease in the private sector, consumer demand decreases, and businesses slow production causing increased unemployment.

Businesses focus on profits and have no incentive to maintain high employment. Our slow economic recovery and continued high unemployment over the past six years have shown that the monetary operations of the Fed have failed. However, Congress can always increase deficit spending or reduce taxes to restore both demand and employment without inducing inflation. Unfortunately, irrational fear of deficits led to austerity instead of the needed government investment to generate a faster economic recovery.

Historically, low deficits precede economic downturns, and surpluses precede depressions. 

Stacked bar chart from BEA data shows dollar flows to/from government, private and foreign sectors quarterly from 1960 Q1 to 2014 Q1. Note government deficit always equals sum of private surplus and net imports.

During five periods in the 19th century the government had budget surpluses, and each was followed immediately by an economic depression. In the 20th century, surpluses in the 1920s immediately preceded the 1929 Great Depression, and the “Clinton” surpluses in the late 1990’s preceded a recession in 2001 and the Great Recession in 2008. Throughout the decade leading up to the 2008 crisis, the combination of surpluses, low deficits, and high imports sucked $1.6 trillion out of the private sector.

Invested in research, education, and infrastructure government expenditures provide the real assets to modernize our public structures and institutions so necessary to assure our children’s future productivity. The “national debt,” which is the sum of deficits since the formation of the republic, unlike a bank loan, is never repaid, and provides financial assets that help secure our financial future. In our economy, only federal deficits result in both net private savings and reduced unemployment.

Both authors are retired PhD physical scientists and students of Modern Money Theory, which describes monetary operations for a sovereign fiat currency.
Bank of England
"Money creation in the modern economy"

History of surpluses and depressions

BEA Data to compute private savings loss FY1998QI through FY2008QI

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