Today I am writing about child cruelty. We would all react to child cruelty in the same way – it is repugnant and undermines the chances of the child maturing into a fully functional adult replete with capacities that promote self esteem and allow meaningful and enduring relationships. So what would we think of child cruelty when a high level government agency is engaged in it? What would we think of a government that was poisoning the minds of the young? Many Americans write to me accusing me of being a communist sympathiser and claiming that freedom was subjugated under those regimes via brutal indoctrination mechanisms embedded in their societal infrastructure. Maybe it was. But the Americans don’t actually have to look very far nor resort to history to find regimes that use indoctrination to oppress their citizens’ free spirits, including the intellectual development of their children. On Thursday, June 3, the Director of the US Congressional Budget Office wrote his Letter to a Seventh Grader. It contains pure indoctrination designed to develop fears about budget deficits at an early age.
The CBO Director starts thus:
A short time ago, I received an interesting letter from a young man in Michigan asking about federal budget deficits. I thought that perhaps other students would be interested in the kinds of questions he asked and how I answered him, so I’ve decided to share my letter to him with all of you. Here’s what I wrote:
The CBO say that they assist “the House and Senate Budget Committees, and the Congress more generally, by preparing reports and analyses. In accordance with the CBO’s mandate to provide objective and impartial analysis, CBO’s reports contain no policy recommendations”. I consider that their analytical reporting to the policy makers to be an influential factor in shaping the course of US fiscal policy.
It is to be encouraged that the Director of a such an influential body in the US consider it his/her role to provide educational material that can be easily distilled for public consumption. I also applaud the idea that kids should start learning things about important matters in the adult world that they are growing up into.
But I don’t support children being fed ideologically-confected half-truths and basic errors about the way macroeconomic policy works within a fiat monetary system.
What follows is the CBO Director’s answer and my re-interpretation based upon an understanding of the way the monetary system actually operates not how the mainstream macroeconomic textbooks portray the system. The student asked five questions and the quotation after the question is the CBO Director’s answer followed in main text by my response which is sort of written at a lower level (but I found it was taking too much time so I cut some corners).
1. What are the primary causes of the current federal budget deficits?
The current large deficits are the result of a combination of factors. These include an imbalance between tax revenues and the government’s spending that began before the recent economic recession and turmoil in the financial markets, sharply lower revenues and higher spending related to current economic conditions, and the budgetary costs of policies put in place by the government to respond to those conditions.
There is no meaning in the term “large deficit”. To understand that we have to consider what makes the budget deficit rise and fall. Further, using the term “imbalance” is inapplicable in the context of a budget outcome because it implies that there is a balance that is desirable. In the case of a budget balance there is no such concept of some single desirable outcome.
The budget deficit is the difference between what the government spends and what it receives in revenue (mostly from taxation collections). We call the extra spending above taxation revenue – net public spending. It is an accounting statement only (that is, records information about the flows of spending and revenue collections) but movements in the deficit does provide information about the state of the economy.
This is because taxation revenue is linked to overall economic activity which is measured by economists as Gross Domestic Product (GDP). GDP is the sum of all the spending in the economy and includes household consumption spending, private investment (building factories etc); net exports (exports minus imports) and government spending. Imports represent a loss of spending to the domestic economy.
The economy responds to this spending by producing output which requires productive inputs to be hired and paid for. So total expenditure equals total output and total income in each period. As long as the flow of spending is stable or growing steadily, output and income will also be stable or growing steadily.
The goal of economic policy should be to ensure that total spending is sufficient to support output levels that will provide enough jobs for all those who want to to work at the current wage levels. At that point we would say we have achieved full employment.
So in terms of defining a desirable budget position, the fact that there is nearly 10 per cent official unemployment in the US at present and high unemployment around the world means that the governments have been excessively restrained in their net spending. Going back to how we might describe the actual budget outcome, we can now appreciate that the current deficits in the US are too small rather than large.
Taxation revenue is linked to GDP because when GDP is growing faster, employment is growing faster, incomes are growing faster and so there is more taxable activity and as a consequence, tax revenue rises. We say that tax revenue is pro-cyclical, which refers to the cycle of GDP – when the cycle is up (good times) GDP is strong and so is tax revenue and vice-versa.
So government revenue is counter-cyclical (against the cycle) because when GDP growth falls so does tax revenue because there is less taxable activity.
Similarly, government welfare payments rise when GDP growth slows because more people become unemployed. So this part of government spending is also counter-cyclical – it rises when the business cycle (indicated by GDP growth) is deteriorating.
We call these components of the budget which are linked to the fortunes of the business cycle – the automatic stabilisers. They are automatic because they do not require any explicit government policy change to work and they stabilise because they pump public net spending into the economy when GDP growth slows and withdraw net public spending when GDP growth is faster.
So the budget balance will move toward or into deficit when the economy is weak because tax revenue is falling and welfare payments are rising.
However, there is also a discretionary component of fiscal policy which influences the budget balance. Governments can decide to change tax rates up and down and increase or decrease government spending.
When there is a collapse in private spending (consumption, investment and/or net exports) then if there is no public response, GDP will fall and the economy goes into recession. Unemployment starts to rise and businesses close.
The automatic stabilisers start pushing the budget into deficit but they can only go so far in arresting the downward spiral of spending. In circumstances like that the government has to increase net spending by altering the discretionary component of fiscal policy. How it does that is not the topic of a consensus with many economists favouring tax cuts and others preferring spending increases. Both sides of the budget can be altered together to get different compositional impacts on overall spending.
But the aim is to support overall spending to ensure the job losses are minimised. As private spending recovers over time, the budget deficit starts to shrink automatically (via the automatic stabilisers). At some point, the government may have to cut back is discretionary net spending to avoid overall aggregate demand (the total spending in the economy) becoming excessive in relation to the capacity of the output side of the economy to produce. If demand outstrips that capacity we get inflation.
Of-course, the government may choose to increase taxes at that point to choke off some private spending.
We also note that the taxation is not levied to raise funds for the government so that it can spend. A sovereign government like the US which issues its own currency is never revenue constrained. That is is can always spend what it likes and should do so to ensure there are enough jobs in the economy. Taxation is a way the government can regulate private spending to ensure total spending is appropriate for the real capacity of the economy to produce output and to ensure there is a desirable mix of public and private goods being produced in the economy.
In this sense, we should never focus on the budget deficit outcome as a standalone item of interest. It is just an accounting statement. The real interest lies in what is happening to production (GDP), employment, unemployment and those sorts of concerns. The budget balance is of no particular interest.
2. How will budget deficits affect people under the age of 18?
The government runs a budget deficit when it spends more on its programs and activities than it collects in taxes and other revenues. The government needs to borrow to make up the difference. When the federal government borrows large amounts of money, it pushes interest rates higher, and people and businesses generally need to pay more to borrow money for themselves. As a result, they invest less in factories, office buildings, and equipment, and people in the future – including your generation – will have less income than they otherwise would.
Also, the government needs to pay interest on the money it borrows, which means there will be less money available for other things that the government will spend money on in the future. Squeezing other spending affects different people in different ways, depending on their individual situations. For example, many young people benefit from government programs that provide money to families in need of food or medical care or to people who have lost their job, or from the financial support the federal government provides to local schools, or from the grants or loans the government offers to help pay for college education.
The CBO Director is grossly misrepresenting what happens in a modern monetary economy. First, the US government does not need to borrow to cover the difference between tax revenue and spending. They choose to borrow and place voluntary constraints on themselves which force them to borrow by law. They erect unnecessary institutions which issue debt $-for-$ to match the net spending. But as the US government is sovereign and issues the US dollar it can never be revenue constrained. So it never needs to fund because it is the monopoly issuer of the currency.
Please read my blogs – On voluntary constraints that undermine public purpose – Debt is not debt – The deficit and debt debate – Debt and deficits again! – Functional finance and modern monetary theory – Saturday Quiz – May 8, 2010 – answers and discussion.
The CBO Director’s answer to you invokes the mainstream analogy that says just as an individual or a household has to raise money before they can spend, so does a national government. So taxes are conceived as providing the funds to the government to allow it to spend. Further, any excess in government spending over taxation receipts then has to be “financed” in two ways: (a) by borrowing from the public; and (b) by printing money. And because they lie and say “printing money” is inflationary, they conclude that the government has to borrow.
However, in a fiat currency system (where the currency is issued by the government and is not backed by a precious metal), the analogy between the household and the government is flawed at the most basic level. The household must work out the financing before it can spend. The household cannot spend first. The government can spend first and ultimately does not have to worry about financing such expenditure.
Second, budget deficits do not put upward pressure on interest rates. In today’s climate, interest rates are very low yet budget deficits are very high. The interest rates the government pays on its debt is stable and very low. It is an absolute lie to say that interest rates rise when deficits rise. Please read my blog – Will we really pay higher interest rates? – for further information.
The claim by the CBO Director about interest rates rising is referred to by economists as the crowding out hypothesis. In this blog – Studying macroeconomics – an exercise in deception – I provide detailed analysis of this hypothesis.
By way of summary, the underpinning of the crowding out hypothesis is the old Classical theory of loanable funds, which is an aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking. The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.
According to this mis-representation of the monetary system, there is a market for loanable funds where savers deposit their saving and borrowers access loans. The interest rate regulates the intentions of the lenders and borrowers.
The supply of funds allegedly comes from those people who have some extra income they want to save and lend out. The demand for funds comes from households and firms who wish to borrow to invest (houses, factories, equipment etc). The interest rate is the price of the loan and the return on savings and thus the supply and demand curves (lines) take the shape they do.
So what would happen if there is a budget deficit? The CBO Director would say, wrongly, that investment falls because when the government borrows to finance its budget deficit, it increases competition for scarce private savings pushes up interest rates. The higher cost of funds crowds thus crowds out private borrowers who are trying to finance investment. This leads to the conclusion that given investment is important for long-run economic growth, government budget deficits reduce the economy’s growth rate.
Doesn’t government borrowing increase the claim on saving and reduce the “loanable funds” available for investors? Does the competition for saving push up the interest rates?
The answer to both questions is no!
The central bank (the Federal Reserve in the US) sets the interest rate. They might decide someday to increase them if demand for goods and services gets too strong in relation to the productive capacity of the economy – rising interest rates are thought to stifle spending.
But the CBO Director’s claims about crowding out assume that savings are finite and the government spending is financially constrained which means it has to seek “funding” in order to progress their fiscal plans. The result competition for the “finite” saving pool drives interest rates up and damages private spending.
Further, the funds that the government borrows come from the government spending those funds in the first place. The government really just borrows its own spending back. Doesn’t that sound crazy? It certainly does and reflects the blind obsession that the orthodox economists have with placing artificial limits on government spending.
There is also no finite pool of saving that is competed for. When a bank makes a loan to a credit-worthy customer it simultaneously creates a deposits which that customer can spend. Any credit-worthy customer can typically get funds. Bank reserves to support these loans are added later – that is, loans are never constrained in an aggregate sense by a “lack of reserves”. The funds to buy government bonds come from government spending! There is just an exchange of bank reserves for bonds – no net change in financial assets involved. Saving grows with income.
But importantly, deficit spending generates income growth which generates higher saving. It is this way that MMT shows that deficit spending supports or “finances” private saving not the other way around.
So budget deficits support stronger GDP growth and higher employment and reduce unemployment. It means less children grow up in jobless households and poverty. It means more public schools and better public transport.
Further, the government is rarely faced with the problem of choosing between spending options. Unless there is no further real output that can be produced, the government can always spend to improve things. So it is an absolute myth that when the government pays interest on public debt that “there will be less money available for other things”. That is a bald-faced lie.
None of the programs that support better outcomes for children should ever be compromised by the size of the deficit or the fact that the government may borrow when it runs a deficit. If there are real resources available at any point in time and there is a need for more government programs “that provide money to families in need of food or medical care or to people who have lost their job” etc then the federal government can always accommodate such spending.
It is a lie to say otherwise. The CBO Director should be ashamed of himself for misleading the children of America.
3. How is the U.S. government working to reduce budget deficits?
The President created a National Commission on Fiscal Responsibility and Reform to draw up plans to address the deficit problem. Most of the people on the commission are Members of Congress. The commission will consider ways to reduce the budget deficit by 2015 as well as ways to improve the long-term budget outlook. Under current government policies, the gap between the government’s spending and revenues in coming years will be large. Therefore, balancing the budget would require significant changes in spending, taxes, or both.
On CBO’s Web site, you can find information about the budget outlook during the next 10 years and over the long term … Congress also has enacted a new law (called “Pay-As-You-Go”) that typically requires legislation that increases spending or lowers tax revenues to include other measures to offset the costs of those changes.
First, there is no reason for the US government to be focusing on a reduction in the deficit. The US labour market has about 17 per cent of its broadly available labour idle and about 10 per cent of immediately available without work. That means the deficit is too small. So at this stage it should be working out targetted job creation programs to mop up the unemployment. The costs of unemployment are huge and span generations.
If a child grows up in a jobless household the research literature shows that that child will be likely to have an unstable work history as an adult and inherit other disadvantages – low self-esteem; propensity to alcohol and substance abuse; poor personal relationships etc.
Any government body that is working to reduce the US budget deficit at this stage is undermining the health of the economy and putting the future of American children in jeopardy.
The “Pay-As-You-Go” legislation mentioned above is an example of what economists call a fiscal rule. It is meant to constrain the government’s ability to run deficits to support GDP growth and employment. In general, such rules undermine the capacity of the government to advance public purpose (that is, raise the living standards in the community).
If you understood the answer I gave to Question 1, then you appreciate that the budget deficit is like a Yo-Yo. It goes up and down when private spending goes down or up. When non-government spending is strong, the budget deficit will fall and may even go into surplus. When non-government spending is weak the budget deficit will increase.
A spending gap is the difference between total non-government spending and the total level of spending required to stimulate enough output production and create enough jobs to fully employ the available labour force.
The budget deficit goes up when there is a spending gap left by non-government spending and falls when the spending gap is reduced. Typically, if the non-government wants to save some of its income (which historically has been the case) then the government sector has to be deficit to support that. If the government sector tries to go into surplus when the non-government is saving then the spending gap will rise and GDP growth will fall (with unemployment rising).
So to impose a given rule on fiscal policy (like a balanced budget rule) ignores the fact that it has to vary with the non-government spending levels if it is to do the job of filling the spending gap. Fiscal rules are mindless constraints on governments imposed by ideologues who dislike public sector spending. Please read my blog – Fiscal rules going mad … – Rescue packages and iron boots – for more discussion on this point.
4. What can people, and especially school-aged children, do to help curb budget deficits?
The most important thing that school-aged children can do to help reduce future deficits is to study hard and acquire the best possible education. This will help you and your classmates get better jobs when you grow up, which will help the economy grow. In turn, a stronger economy will produce higher tax receipts for the government, which will lower the deficit.
When young people get jobs, they should be sure to save some of the money they earn. Through a fun and important bit of math called compounding, savings of small amounts can grow over time into significant amounts. For the economy as a whole, the more people save, the more money is available for businesses to invest in factories, office buildings, and equipment. For individuals and families, more savings provide a financial cushion in times of economic difficulty. In particular, more savings can help people pay large medical expenses or save their home in case they lose their job or become ill, thus helping them avoid needing government assistance.
People of all ages can also help to reduce the deficit by learning how the government spends money and from whom the government collects money. Understanding the current budget is essential for choosing intelligently among different ways to change programs and policies in order to reduce deficits.
First, the focus of policy should be on reducing unemployment and getting businesses running again. It should be on maintaining viable public services and ensuring that those in need have enough to heat and have adequate housing. The US is in a crisis at present and there will be a substantial and lasting impoverishment of its citizens coming out of this economic meltdown.
Those who want to curb the deficit are those who don’t care for the well-being of the disadvantaged or the quality of public infrastructure including the schools that the majority of US children go to for their education.’
So children should be badgering their parents and telling them to lobby their elected representatives to resist the deficit terrorism that is undermining the their future.
Second, the one of the most durable investments we can make in our children is education. The CBO Director is correct in encouraging children to study hard and get the best possible education. But children who grow up in jobless households have difficulties completing their education. So the government should be doing everything it can to reduce unemployment.
If you want to provide for the future then you don’t waste 17 per cent of your available labour resources now. The people who make up that 17 per cent have families so the scale of disadvantage becomes extensive.
Third, when there is high unemployment, school leavers face the prospects of being locked out of employment. With slow GDP growth in the US at the present and the government being pressured to cut back its deficit, then the large pool of unemployed will take years to reduce. This reduces the chances of all labour market entrants of getting a satisfactory job and suppresses the capacity of workers to gain wages growth commensurate with productivity growth.
5. If I am to convey one key message to my school regarding the federal budget deficit, what would it be?
The prospect of budget deficits for many years in the future is a serious problem for our country. Ultimately, people in the United States will have to bring into balance the amount of services they expect the government to provide, particularly in the form of benefits for older Americans, and the amount of taxes they are willing to send to the government to finance those services. Because it takes a long time to implement major policy changes, deciding what those changes will be is an urgent task for our citizens and for our policymakers.
The CBO Director is misleading all the US school kids.
There is no serious problem with the US federal budget deficits. The problem is that the private sector has over-borrowed because the same people who are now claiming the budget deficits are serious also pressured the government to deregulate the financial markets. That allowed the bankers to engage in criminal and incompetent lending practices which cause the debt crisis in the 2007.
Banks extended loans that could not be repaid and created complex financial products that were too risky and eventually the game collapsed. That choked credit in the economy which affected business investment and that flowed onto to other components of non-government spending.
The government had to increase their discretionary spending and thus increase their deficits to make up, at least, some of this non-government spending collapse. Otherwise the crisis would have been much worse than it already was.
So the key message about the budget deficit is by rising many more jobs that would have been lost were saved. Many more families than otherwise retained their incomes. Many more kids are growing up in families that have the resources that allow them to develop and participate broadly in society as a result of the deficits.
Around the world, major public infrastructure projects are being completed as a result of governments in various countries going into deficit to address the non-government spending collapse. This infrastructure (hospitals, schools, roads, etc) will deliver enduring benefits for the years to come and will still be delivering benefits when the school children of today have become adults.
There is no budget crisis in the US at present other than that which is being manufactured by those who do not like public sector involvement in the economy. They are pressuring the government to reduce the deficit when in fact it should be increased.
The argument that the government needs more tax revenue is erroneous. The US government can spend without raising revenue.
When the CBO Director talks about benefits for older Americans etc he is referring to the so-called intergenerational debate. The argument is that as our populations age, the strains on public health and pensions will become unsustainable. This argument is behind the push by conservatives in the US to undermine the standard of the health and pension system there.
Financial commentators often suggest that budget surpluses are required to save up funds to provide for the needs of the ageing society.
However, these arguments are all wrong. This idea that accumulated surpluses allegedly “stored away” will help government deal with increased public expenditure demands that may accompany the ageing population lies at the heart of the intergenerational debate misconception.
While it is moot that an ageing population will place disproportionate pressures on government expenditure in the future, it is clear that the concept of pressure is inapplicable because it assumes a financial constraint.
A sovereign government in a fiat monetary system is not financially constrained.
There will never be a squeeze on “taxpayers’ funds” because the taxpayers do not fund “anything”. The concept of the taxpayer funding government spending is misleading. Taxes are paid by debiting accounts of the member commercial banks accounts whereas spending occurs by crediting the same. The notion that “debited funds” have some further use is not applicable.
When taxes are levied the revenue does not go anywhere. The flow of funds is accounted for, but accounting for a surplus that is merely a discretionary net contraction of private liquidity by government does not change the capacity of government to inject future liquidity at any time it chooses.
There will also not be a burden imposed on future tax payers. The government budget is not a “bridge” that spans the generations in some restrictive manner. Each generation is free to select the tax burden it endures. Taxing and spending transfers real resources from the private to the public domain. Each generation is free to select how much they want to transfer via political decisions mediated through political processes.
When I argue that there is no financial constraint on federal government spending they are not, as if often erroneously claimed, saying that government should therefore not be concerned with the size of its deficit. We are not advocating unlimited deficits. Rather, the size of the deficit (surplus) will be market determined by the desired net saving of the non-government sector.
This may not coincide with full employment and so it is the responsibility of the government to ensure that its taxation/spending are at the right level to ensure that this equality occurs at full employment. Accordingly, if the goals of the economy are full employment with price level stability then the task is to make sure that government spending is exactly at the level that is neither inflationary or deflationary.
This insight puts the idea of sustainability of government finances into a different light. The emphasis on forward planning that has been at the heart of the ageing population debate is sound. We do need to meet the real challenges that will be posed by these demographic shifts.
But if governments continue to try to run budget surpluses to keep public debt low then that strategy will ensure that further deterioration in non-government savings will occur until aggregate demand decreases sufficiently to slow the economy down and raise the output gap.
So the intergeneration challange is not a financial crisis that might be real crisis if policy now undermines the capacity of the economy to provide real output in the future.
Are we really saying that there will not be enough real resources available to provide aged-care at an increasing level? That is never the statement made. The worry is always that public outlays will rise because more real resources will be required “in the public sector” than previously.
But as long as these real resources are available there will be no problem. In this context, the type of policy strategy that is being driven by these myths will probably undermine the future productivity and provision of real goods and services in the future.
It is clear that the goal should be to maintain efficient and effective medical care systems. Clearly the real health care system matters by which I mean the resources that are employed to deliver the health care services and the research that is done by universities and elsewhere to improve our future health prospects. So real facilities and real know how define the essence of an effective health care system.
Further, productivity growth is essential and publicly-funded research and development will help maximise that.
For all practical purposes there is no real investment that can be made today that will remain useful 50 years from now apart from education. Unfortunately, tackling the problems of the distant future in terms of current “monetary” considerations which have led to the conclusion that fiscal austerity is needed today to prepare us for the future will actually undermine our future.
The irony is that the pursuit of budget austerity leads governments to target public education almost universally as one of the first expenditures that are reduced.
Most importantly, maximising employment and output in each period is a necessary condition for long-term growth. The emphasis in mainstream integeneration debate that we have to lift labour force participation by older workers is sound but contrary to current government policies which reduces job opportunities for older male workers by refusing to deal with the rising unemployment.
Anything that has a positive impact on the dependency ratio is desirable and the best thing for that is ensuring that there is a job available for all those who desire to work.
Further encouraging increased casualisation and allowing underemployment to rise is not a sensible strategy for the future. The incentive to invest in one’s human capital is reduced if people expect to have part-time work opportunities increasingly made available to them.
But all these issues are really about political choices rather than government finances. The ability of government to provide necessary goods and services to the non-government sector, in particular, those goods that the private sector may under-provide is independent of government finance.
Any attempt to link the two via fiscal policy “discipline”, will not increase per capita GDP growth in the longer term. The reality is that fiscal drag that accompanies such “discipline” reduces growth in aggregate demand and private disposable incomes, which can be measured by the foregone output that results.
Clearly surpluses helps control inflation because they act as a deflationary force relying on sustained excess capacity and unemployment to keep prices under control. This type of fiscal “discipline” is also claimed to increase national savings but this equals reduced non-government savings, which arguably is the relevant measure to focus upon.
The idea that it is necessary for a sovereign government to stockpile financial resources to ensure it can provide services required for an ageing population in the years to come has no application. It is not only invalid to construct the problem as one being the subject of a financial constraint but even if such a stockpile was successfully stored away in a vault somewhere there would be still no guarantee that there would be available real resources in the future.
The best thing to do now is to maximise incomes in the economy by ensuring there is full employment. This requires a vastly different approach to fiscal and monetary policy than is currently being practised.
Third, if there are sufficient real resources available in the future then their distribution between competing needs will become a political decision which economists have little to add.
Long-run economic growth that is also environmentally sustainable will be the single most important determinant of sustaining real goods and services for the population in the future. Principal determinants of long-term growth include the quality and quantity of capital (which increases productivity and allows for higher incomes to be paid) that workers operate with.
Strong investment underpins capital formation and depends on the amount of real GDP that is privately saved and ploughed back into infrastructure and capital equipment. Public investment is very significant in establishing complementary infrastructure upon which private investment can deliver returns. A policy environment that stimulates high levels of real capital formation in both the public and private sectors will engender strong economic growth.
If we adequately fund our public universities to conduct more research which will reduce the real resource costs of health care in the future (via discovery) and further improve labour productivity then the real burden on the economy will not be anything like the scenarios being outlined in the “doomsday: reports. But then these reports are really just smokescreens to justify the neo-liberal pursuit of budget surpluses.
Please read my blog – Democracy, accountability and more intergenerational nonsense – Another intergenerational report – another waste of time – for more discussion on this point.
The Saturday Quiz will be back sometime tomorrow – even harder than last week!
That is enough for today!