Monday, November 29, 2010

The Impoverished, and Impoverishing, Debate about Fiscal Deficits

It is like living in a dream—a very bad dream. Everything seems at once real and imaginary, serious and deliriously impossible. The language is familiar and incomprehensible. And it seems there is no waking up, ever.

I’m talking about the “debate” over America’s fiscal deficits, which is what I stumbled into after a night of much happier visions. Now, according to this morning’s New York Times, the left has weighed in with its own plans to achieve deficit stability. Of course, it is more reasonable than the pronunciamenti of the Simpson-Bowles cabal, with a wiser assortment of cuts and more progressive tax adjustments. Still, it is part of the same bizarre trance, disconnected from the basic laws of income accounting.

All you need to know is the fundamental identity. In its financial balance form, it appears as

Private Deficits + Public Deficits ≡ Current Account Balance

If the US runs, say, a 4% CA deficit, the sum of its net public and private deficits must equal 4%. You can’t alter this no matter how you juggle budgets.

Add to this one more piece of wisdom, which we should have learned from the past three years, even if we were blind to everything else: private debts matter as much as public ones. The indebtedness of households, corporations and financial entities can bring down the economy as readily as the profligacy of the public sector. In fact, in the grip of a crisis (which we have not yet escaped), private deficits are far harder to finance because of their greater default risk. That’s why governments slathered themselves with red ink: they borrowed to assume the debts that private parties could no longer bear.

So what does this mean for US fiscal deficits? Isn’t it obvious? Public deficits can be brought down only to the extent that the private willingness and capacity to borrow increases and current account (mostly trade) deficits shrink. There is still an important discussion to be had over the size and composition of revenues and expenditures, of course, but this is only about how, not how much. To put it differently, if private deficits and the external position of the US economy remain as they are, planned deficit reduction by the government cannot be realized. Revenues will fall along with spending, the economy will take a dive, and actual fiscal deficits will be unmoved. This is guaranteed by the laws of arithmetic, and you can see such a process happening in real time in the peripheral Eurozone countries.

What can break this fall? The current account constraint can be relaxed as falling incomes drive falling imports, but this entails an economic catastrophe unless devaluation can do the job instead. Or the borrowing capacity of the private sector can rise, but this is inconceivable in a collapsing economy. Or, facing the abyss, those who run the show can dispense with all the nonsense about fiscal prudence in isolation from surrounding economic conditions, and open the spigots once again.

My prediction: if there is deficit-cutting in the US of any sort before the private sector is prepared to take on more debt and, especially, approximate trade balance is restored, we will see exactly this third scenario. The economy will take a dive, political leaders (whether of the latté or tea persuasion) will spend like crazy, and fiscal deficits will be larger than ever. The deficit-cutting debate is delusional.


Dan Crawford said...

May I repost at AB Peter?


Peter Dorman said...

Dan: It's all yours.

TheTrucker said...

I have been messing around with some cartoons that try to speak to the general public about the FED's quantitative easing. But I am trying to convert this reality of QE3 into a sustained action on the part of the FED. In my opinion, there should be much fewer bond sales to the public and more bond sales to the FED. There should also be an increase in the tax on very high ordinary incomes, but the later opinion is more a cry for increased progressivity of the tax code than a desire for tax increases. I am convinced that more high income brackets need to exist above a million bucks.

Open this in another window and then play it.

You can also select and play
"QE2 and Reality Economics".

I hope you enjoy these... Maybe I am full of it and maybe not.

Sandwichman said...

"The deficit-cutting debate is delusional."

That's right. But it is also a symptom of an even deeper delusion. And if you can understand the dimensions of that deeper illusion, the 'logic' of the more superficial illusion becomes clear. Debating the deficit-cutting delusion is like jousting with the shadows on the wall of the cave.

JW Mason said...

Public deficits can be brought down only to the extent that the private willingness and capacity to borrow increases and current account (mostly trade) deficits shrink.

This isn't true.

The numbers that matter aren't the deficits in isolation, but deficits as a fraction of income (GDP). Faster nominal GDP growth will reduce both private and public sector debt ratios simultaneously, no matter what happens to the current account.

Unknown said...

The numbers that matter aren't the deficits in isolation, but deficits as a fraction of income (GDP). Faster nominal GDP growth will reduce both private and public sector debt ratios simultaneously, no matter what happens to the current account.

If the FED prints a lot of money and uses it to retire current debt held by the public this improves the trade imbalance regardless of whether the public wants to save or not. The current problem is DEBT and tightening of credit. We have already entered the deflationary spiral. That happened when the housing bubble popped. Inflation in moderation is needed and we do not have it. Further, the Republicans, swooning for the good old days of the Great Depression, are now launching an all out attack on the FED.

Simply stated: The FED prevented the second Great Depression by showering money on the thieves that caused it. For the common people to ever catch up is almost impossible as those with all the money have control over the educational apparatus.

Monetary economics is so far beyond the intellectual abilities of the common voter that the Republicans can lie at will and make it stick. Arithmetic models and relationships have no effect whatsoever. But cartoons and humor are a different matter.

The number of lies in this cartoon are too numerous to count. And only one of the lies need to stick and the job is done. It does not matter which of the lies is ingested and made part of an individual's knowledge base. That one lie is now part of the individual's basis for how the world works. Propaganda politics trumps economics and rationality every time.

What does this have to do with Peter Dorman's article about the accounting identity? It is that at some level that identity will always hold true. But the public deficit (or the public debt) in a global economy will include the debt instruments held by the Chinese and the savings of the Chinese (a surplus?). The books always balance because the government owes exactly what the savers have saved. I have no idea what the "current account" would be in that scenario. Unless there is a full and comprehensible definition of the terms of the identity, the identity conveys nothing. When we see "debt owed to the public" when talking about the national debt, we know that this is debt owed to the private sector only because we have thought about it a lot.

Don Levit said...

You mentioned the Fed buying debt held by the public.
Debt held by the public is something like $9 trillion.
Seems like a quick and convenient way to help out present and future generations.
It looks to me, though, that it is too good to be true.
How would this work out to our benefit, both
short and long term?
I am interested in learning more details of the symptom of a deeper delusion.
It sounds intriguing.
Don Levit

JW Mason said...

The problem with Dorman's analysis, here and in previous posts, is he is talking about absolute net debt. But that is not an economically meaningful number. What matters -- what everyone on earth means by leverage -- is *gross* debt as a *ratio* to income or GDP (or sometimes, for private actors, to net worth.)

If you loan me $100 and I use it to buy an asset worth $100, while my income doesn't change, I am more leveraged. No one else's leverage need have changed at all. If I then give you the asset in return for the extinction of the debt, I am less leveraged. Again, no one else's leverage need change. Dorman's accounting-identity approach, which incorrectly uses net rather than gross values, completely misses these changes.

Now as a matter of fact I think his conclusion -- that it doesn't make sense to talk about reducing public sector borrowing while the private sector is trying to deleverage -- is correct. but this is because of *behavioral* relationships that mean that fiscal tightening is likely to reduce income. Accounting identities are irrelevant to the real story, since they tell us nothing about the evolution of income.

Unknown said...

For Don Levit:

It does not matter from whom the FED buys these government bonds/T-bills. The fact is, that these debt instruments will be traded for cold hard cash that is, indeed printed by the FED. Such a trade expands the _LIQUID_ part of the money supply and that is what has all the monetarist people screeching about the inflation monster. They are still hung up on that fractional reserves crap that allows the banks to loan 10 times reserves. The reality is that the banks are so full of money at present that loading them up with more of it won't change a thing. The banks can't force people or businesses to borrow money. So the net effect of FED buying is to increase the price of T-Bills as the FED bids against all other parties that want T-Bills. The bills are fixed duration and fixed yield. A ten thousand bill trades for the current value (the amount it will take to make the certificate worth $10k at maturity). It is an inflation bet.

What I find interesting in all this crap is that we need a tax increase on the high rollers to get some of this money out of the system. And it's what we cannot get. The way out of this mess is higher taxes on the rich and more stimulus. And the Republicans are blocking both.

If the FED is right (banks won't use the extra money) then there will be no jump in inflation at all. The probable near term result is a decline in the dollar (which is good). Arbitrage among the banks will keep interest rates low for now, but if the inflation monster gets lose we will have a problem. Inflation fear is why the T-Bills are sold in the first place.

Unknown said...

More for Don:

In the chartal view of fiat money, government creates the money (even if it uses a central bank to do it). The money has value because of taxation. If there is no taxation, then there is no reason for those in control of the economy to try to earn the money. At the end of every series of trades lies an individual that has all he wants, but must pay a tax. He can only use the government's money to pay the tax so he must contrive a way to get this money.

All of the government instruments including federal reserve notes and clearing balances is the real money supply and is all the money ever created by government and not yet taxed back out of the economy. T-Bills are parking lots for money. These parking lots keep money out of circulation. Money is never destroyed but for a tax.

Don Levit said...

Thanks for taking the time to respond.
You seem to know quite a bit about the Federal Reserve.
I recently bought the book "The Creature from Jekyll Island."
I hope it can clear some things up for me.
Don Levit

Unknown said...

The book you have chosen to read is a conspiracy theory on how the FED came into being. But the FED has changed in many ways since its inception. For instance, it was in the 1960's that the congress forced the FED to deliver its earnings on created money to the Treasury. These are the sort of facts that do not appear in the "Jekyll" book. There is also an extreme portrayal of the fractional reserve system that does not really hold up to scrutiny. Regardless of how much money the banks _CAN_ lend, they can't force people to borrow it. And the lending is more based on interest rates than on quantity of liquid reserves. In the broader view, the interest rates and the willingness of banks to loan is also based on the reward they can receive from not loaning. If they can borrow at .25% and buy 5 year treasuries that give them 2% then they will not be interested in lending any money at all.

Don Levit said...

Thanks for your reply.
I appreciate those comments about the book, for it is better to view it with a critical eye.
Everyone is biased, everyone has an agenda, including the author of that book.
Is there any book you could recommend which may be more objective and accurate about the Fed?
Don Levit