Baker on deficits

Overcoming the Debt Trap

By Dean Baker

The deficit hawk gang is again trying to take our children hostage with new threats of enormous debt burdens. As in the past, most of what they claim is very misleading, if not outright false.

Agreed.

First and foremost, the basis of the bulk of their horror story has nothing to do with spending being out of control, but rather a broken private health care system. If per person health care costs were comparable to the costs in any other wealthy country, we would be looking at long-term budget surpluses, not gigantic deficits. This would lead honest people to focus their energies on fixing the US health care system, but not the deficit hawk gang.

I’d guess the deficit would be much the same as it grew counter cyclically with the automatic stabilizers kicking in as the economy weakened to the point the deficit got large enough to where it provided the income and net financial assets needed to stabilize output and employment. Not that there isn’t much to be done to fix the US health care system.

But there is another part of their story that contains some truth. The government is borrowing large amounts of money right now to sustain demand in the wake of the collapse of private sector spending following the deflation of the housing bubble.

Yes, the government is spending large amounts to sustain demand, but that spending is not dependent on borrowing, though it is associated with borrowing.

If the deficit continues on the projected path, the country will substantially increase its debt burden over the course of the decade.

Yes, the deficit could go higher but ‘burden’ isn’t the right term. The national debt is the dollar savings of the ‘non government’ sectors, and as such lightens the financial burden of those sectors.

A higher debt burden will imply much larger transfers from taxpayers to bondholders in future years. This will require either higher taxes or cuts in other spending.

Not necessarily. Taxes function to regulate aggregate demand. So tax increases and/or spending cuts would be in order only should aggregate demand be deemed too high, evidenced by unemployment being too low. In that case, taxes increases and/or spending cuts would serve to cool demand, not to make payments on the debt. Also, the interest on the debt only alters demand if it gets spent, which does not necessarily happen. Japan has never spent a penny of their interest income, for example.

Alternatively, the government could run larger deficits.

The informed approach is, for a given amount of spending, to adjust taxes to the level that corresponds to desired levels of employment, whatever size deficit that might mean.

However, in a decade or so, if the economy is again near full employment, higher deficits will either lead to higher inflation if the Fed opts to accommodate the deficits, or higher interest rates if it targets a low rate of inflation. The latter could crimp investment and long-run growth.

Should the informed approach be taken, and taxes lowered and the deficit thereby increased to the level that coincides with full employment, yes, the government could then go too far and keep taxes too low and sustain excess demand that drives up prices. This would be the case whether the Fed ‘accommodated the deficits’ or not. And if the Fed did elect to implement policy to raise rates to slow inflation, the point would be to slow nominal spending without slowing real spending. And in any case there is no such thing as crowding out investment, as investment is a function of consumption, with demand driving prices to a level where investment is funded.

For these reasons, it is desirable to prevent the debt from reaching the levels now projected, even if the outcome may not be the disaster promised by the deficit hawks.

Nor is the outcome that promised by the deficit doves. US deficits incurred as a by product of fiscal balance that sustains full employment do not have negative side effects if managed by an informed government.

There is a simple way to avoid a sharp rise in the interest burden associated with a higher debt. The Federal Reserve Board can buy and hold the debt that is currently being issued by the Treasury to finance the deficit.

The Fed buying the debt is functionally the same as the Treasury not issuing it. And I have supported the Treasury not issuing anything longer than 3 month T bills for a long time, etc. More on that below.

The logic of this is straightforward. If the Fed holds the debt, then the interest on the debt is paid to the Fed. The Fed then returns the interest to the Treasury each year, meaning the net cost to the government is zero.

Not exactly. What that policy would do is add the deficit spending to bank reserve balances held at the Fed, which currently pay what for all practical purposes is the overnight rate of interest targeted by the Fed. The Fed controls the fed funds rate by offering and paying interest on the overnight balances held at the Fed. This rate is currently .25%. Interestingly, 3 month Treasury bills are purchased to yield only .14% for technical reasons. I do support the policy of the Treasury not issuing securities longer than 3 months, which will produce similar results. But in either case, should the Fed decide to hike rates the balances created by federal deficit spending will earn those rates under current institutional arrangements. One way to avoid all interest payments on deficit spending would be to increase required reserves for the banking system and not pay interest on them. That, however, becomes a ‘bank tax’ that is passed through to all borrowers, passing the interest rate burden on to them.

This is not slight of hand. The point is that the economy has a huge amount of idle resources in the form of unemployed workers and excess capacity. In this situation, the increased demand created by government spending does not have to come at the expense of existing demand. The economy can simply expand to fill the additional demand created by larger deficits.

This is 100% true and I fully support the policy of adjusting the fiscal balance to that which coincides with full employment, without consideration of the interest paid on balances created by deficit spending, as above.

While that may not be true in five or ten years, assuming the economy is again near full employment, right now deficits need not lead to either higher interest rates or higher inflation.

Again, fully agreed with the conclusion.

In fact, the financial markets and the “bond market vigilantes” should even support the decision to have the Fed purchase and hold the government debt being issued now to finance the deficit. This practice will lessen the future interest burden on the Treasury. In fact, interest should be seen as an entitlement like Social Security and Medicare since it is paid each year without new authorization by Congress. If the deficit hawks had any integrity they would be insisting that we should require the Fed to hold the government debt issued during this downturn. It is a sure fire way to substantially reduce entitlement spending.

Again, the Fed buying Tsy securities is functionally identical to and nothing more than the Treasury not issuing it in the first place. Nothing more.

Of course, no one ever accused deficit hawks of being consistent. Not only do they not advocate having the Fed buy and hold the debt, they don’t even want this policy discussed in their “everything is on the table” sessions. Keeping this simple solution off the table makes good sense if your concern is not deficit reduction, but rather cutting Social Security, Medicare and other important social programs.

Fortunately, the rest of us don’t have to be bound by the deficit hawks’ agenda. If Social Security and Medicare are on the table, then having the Fed hold the debt better be on the table; otherwise, this exercise is just a charade to cut the country’s most important social programs.

Social Security has no business being on the table even under current policy of issuing longer term Treasury securities, no matter how large the deficit might be, if there is excess capacity/unemployment. How could it possibly make sense to cut aggregate demand in the current environment? It’s not like our seniors are consuming scarce real resources and creating shortages for the rest of us.

This will be a great lie detector test. We will soon know whether the deficit hawks care about the interest burden on our children or just want to destroy the social safety net.

The doves are on the right side of this argument, but if they don’t get their act together on monetary operations and reserve accounting it looks like they will continue to go down to defeat with what are inherently winning hands, with all of us the losers.

SZ News: ‘Hope’ of SNB Countering Franc Gains

The Swiss have been buying euro all along to support their exporters (at the expense of the macro economy but that’s another story).

No doubt other nations are/will do same, also to protect exporters, and do the best they can managing risk of their euro denominated financial asset portfolios.

Over the last two years or so the ‘automatic stabilizers’ in the euro zone added to deficits and weakened the currency, helping to support domestic demand and exports, but threatening solvency as the national govts are credit constrained.

The credit constraint aspect blocked further fiscal easing, and caused a proactive move toward fiscal tightening.

If the easing phase was sufficient to cause them to ‘turn the corner’ with regards to GDP, which appears to be the case, it is possible GDP growth can remain near 0 with the austerity measures, while the firming currency works to slowly cut into exports.

In other words, the euro zone may, in its own way, also be going the way of Japan, but with the extreme downside risk that the austerity measure cut too deep and the deflationary forces get out of hand, as they are flying without a fiscal safety net.

Switzerland’s Gerber Sees ‘Hope’ of SNB Countering Franc Gains

By Simone Meier

June 4 (Bloomberg) — Jean-Daniel Gerber, the Swiss
government’s head of economic affairs, said he’s counting on the
central bank to counter any “excessive” gains of the franc to
protect the country’s export-led recovery.

“I’m of course concerned” about franc gains, Gerber, who
heads the State Secretariat for Economic Affairs, told Cash in
an interview published on the newspaper’s website today. “But
there’s hope that the SNB will be able to keep its promise of
countering an excessive appreciation of the franc.”

The Swiss currency has been pushed higher on concerns that
a Greek debt crisis will spread across the 16-member euro region
and hurt an economic recovery. The Swiss National Bank has
countered franc gains by purchasing billions of euros at an
unprecedented pace to protect exports and fight deflation risks.

The franc today breached 1.40 per euro for the first time
since the single currency was introduced in 1999. It
strengthened to as much as 1.3867 against the euro, trading at
1.3942 at 3:29 p.m. in Zurich.

Gerber said that while it’s “up to the central bank” to
decide on the extent of currency purchases, the SNB’s ability to
counter franc gains is “theoretically unlimited.”

“You can always counter an appreciation if you want to,
you just have to inject money into the market, purchase euros,
and that’s how you’re able to stabilize the value of the franc
versus the euro more or less,” he said. “But of course it
could have considerable negative side effects, namely of larger
liquidity sparking inflation if it isn’t re-absorbed.”

Tax Hikes and the 2011 Economic Collapse, Laffer

Tax Hikes and the 2011 Economic Collapse

By Arthur Laffer

June 7 (WSJ) —People can change the volume, the location and the composition of their income, and they can do so in response to changes in government policies.

It shouldn’t surprise anyone that the nine states without an income tax are growing far faster and attracting more people than are the nine states with the highest income tax rates. People and businesses change the location of income based on incentives.

Likewise, who is gobsmacked when they are told that the two wealthiest Americans—Bill Gates and Warren Buffett—hold the bulk of their wealth in the nontaxed form of unrealized capital gains? The composition of wealth also responds to incentives. And it’s also simple enough for most people to understand that if the government taxes people who work and pays people not to work, fewer people will work. Incentives matter.

People can also change the timing of when they earn and receive their income in response to government policies. According to a 2004 U.S. Treasury report, “high income taxpayers accelerated the receipt of wages and year-end bonuses from 1993 to 1992—over $15 billion—in order to avoid the effects of the anticipated increase in the top rate from 31% to 39.6%. At the end of 1993, taxpayers shifted wages and bonuses yet again to avoid the increase in Medicare taxes that went into effect beginning 1994.”

Just remember what happened to auto sales when the cash for clunkers program ended. Or how about new housing sales when the $8,000 tax credit ended? It isn’t rocket surgery, as the Ivy League professor said.

On or about Jan. 1, 2011, federal, state and local tax rates are scheduled to rise quite sharply. President George W. Bush’s tax cuts expire on that date, meaning that the highest federal personal income tax rate will go 39.6% from 35%, the highest federal dividend tax rate pops up to 39.6% from 15%, the capital gains tax rate to 20% from 15%, and the estate tax rate to 55% from zero. Lots and lots of other changes will also occur as a result of the sunset provision in the Bush tax cuts.

Tax rates have been and will be raised on income earned from off-shore investments. Payroll taxes are already scheduled to rise in 2013 and the Alternative Minimum Tax (AMT) will be digging deeper and deeper into middle-income taxpayers. And there’s always the celebrated tax increase on Cadillac health care plans. State and local tax rates are also going up in 2011 as they did in 2010. Tax rate increases next year are everywhere.

Now, if people know tax rates will be higher next year than they are this year, what will those people do this year? They will shift production and income out of next year into this year to the extent possible. As a result, income this year has already been inflated above where it otherwise should be and next year, 2011, income will be lower than it otherwise should be.

Also, the prospect of rising prices, higher interest rates and more regulations next year will further entice demand and supply to be shifted from 2011 into 2010. In my view, this shift of income and demand is a major reason that the economy in 2010 has appeared as strong as it has. When we pass the tax boundary of Jan. 1, 2011, my best guess is that the train goes off the tracks and we get our worst nightmare of a severe “double dip” recession.

In 1981, Ronald Reagan—with bipartisan support—began the first phase in a series of tax cuts passed under the Economic Recovery Tax Act (ERTA), whereby the bulk of the tax cuts didn’t take effect until Jan. 1, 1983. Reagan’s delayed tax cuts were the mirror image of President Barack Obama’s delayed tax rate increases. For 1981 and 1982 people deferred so much economic activity that real GDP was basically flat (i.e., no growth), and the unemployment rate rose to well over 10%.

But at the tax boundary of Jan. 1, 1983 the economy took off like a rocket, with average real growth reaching 7.5% in 1983 and 5.5% in 1984. It has always amazed me how tax cuts don’t work until they take effect. Mr. Obama’s experience with deferred tax rate increases will be the reverse. The economy will collapse in 2011.

Consider corporate profits as a share of GDP. Today, corporate profits as a share of GDP are way too high given the state of the U.S. economy. These high profits reflect the shift in income into 2010 from 2011. These profits will tumble in 2011, preceded most likely by the stock market.

In 2010, without any prepayment penalties, people can cash in their Individual Retirement Accounts (IRAs), Keough deferred income accounts and 401(k) deferred income accounts. After paying their taxes, these deferred income accounts can be rolled into Roth IRAs that provide after-tax income to their owners into the future. Given what’s going to happen to tax rates, this conversion seems like a no-brainer.

The result will be a crash in tax receipts once the surge is past. If you thought deficits and unemployment have been bad lately, you ain’t seen nothing yet.

Yes, those are very strong forces, especially for the second half.

They will also cause tax collections to go up this year, reducing non gov net financial assets which means we go into next year’s slow down that much weaker financially.

The thing that can reverse it is an acceleration of borrowing to spend in the domestic private sectors. That’s usually from housing, cars, maybe cap ex, commercial construction, etc. But those traditional areas of credit growth aren’t showing any signs of being able to take up the slack, at least yet. while the employment picture is modestly improving (see Karim’s work on total hours worked) seems to me it has a long way to go before it generates robust credit growth.

And, of course, the external risks remain.

G20 rules out fiscal expansion

G20 Says Expansionary Fiscal Policy Not Sustainable

The G20 has dropped its support for fiscal expansion. The deficit hawks are prevailing. But why is that? We all either know or should know that operationally Federal spending is not constrained by revenues, as Chairman Bernanke stated last year, when asked on ’60 Minutes’ by Scott Pelley where the funds given to the banks came from :

“…we simply use the computer to mark up the size of the account that they have with the Fed.”

We know that when the Fed spends on behalf of the Treasury it simply credits a member bank or foreign government’s reserve account at the Fed.

We know that a US Treasury security is a credit balance in a securities account, also at the Fed.

We know that buying a Treasury security means US dollars (numbers on the Fed’s spreadsheet) shift from a Fed reserve account to a Fed securities account, which adds to the ‘national debt.’

We know that government deficits = ‘non government’ saving (net dollar financial assets) to the penny, as a matter of national income accounting.

And we know paying off the Treasury securities happens continuously when Treasury securities mature and the Fed simply shifts those US dollars from the securities account back to a Fed reserve account (including the interest).

So why should we care if US dollars are in a Fed reserve account or a Fed securities account?

We should not, yet most still do.

There are two featured sides to the argument, pro and con, deficit hawks and deficit doves. The deficit hawks aren’t the problem. They have no argument that makes any sense as a point of simple monetary operations. There is no such thing as the Federal Government running out of money, being dependent on foreigners or anyone else for funding to be able to spend, and the US is not the next Greece.

The problem is the deficit doves featured by the media don’t understand actual monetary operations and reserve accounting, and so they take the same ‘fundamentally wrong’ positions as the deficit hawks. The difference is nothing more than timing and degree. In effect, the media is showing only one side of the argument.

To be a credible media deficit dove, you agree deficits are ‘bad’ but in the long term, arguing that in the short term we need tax cuts or spending increases now, and deficit reduction later. You agree that deficits can be too high, but argue they have been higher, particularly in World War II, so current levels should be easily manageable, further agreeing there is a level that could not be manageable. You agree markets could be ‘unfriendly’ and a lack of confidence could translate into far higher interest rates, but argue that the current low rates for Treasury securities are the markets telling us that currently they do have confidence in the US and they are eager to fund current deficits. You agree that ‘bang for the buck’ matters and support tax cuts and spending increases based on higher ‘multipliers.’

The two ‘sides of the story’ are in fact on the same side, just with differing degrees. The media does not feature the true deficit dove story. Nor do any of the true doves have even a small piece of the administration’s ear, or the ear of anyone in Congress willing to speak out. There are maybe a hundred of them, including many senior economics professors. The nagging question is why this professional, highly educated, highly experienced collection of true doves, who happen to be correct and could get us back to full employment and prosperity in reasonably short order, does not get a fair hearing.

The answer may be credentials. My BA in Economics from the University of Connecticut in 1971 doesn’t cut it, nor the fact that the very large fund I managed was the highest rated firm for the time I ran it. And my net worth never getting anywhere near a billion hasn’t helped either. Seems billionaires get celebrity status and airtime for just about anything they want to say.

The same is true of the Economics professors who’ve got it right. Without being from and at the usual ‘top tier’ schools none can even get published in main stream economics journals, where submissions featuring obvious accounting realities are routinely rejected. In fact, any economist who states accounting identities and operational realities such as ‘deficits = savings’ or ‘loans create deposits’ or ‘Federal spending is not constrained by revenues’ is immediately labeled ‘heterodox’ and unworthy of serious mainstream consideration. Even the late Wynne Godley, who did have reasonable credentials as head of Cambridge Economics, and was the number one UK economics forecaster, was labeled ‘unorthodox’ because his mathematical models featured the deficits = savings accounting identity.

The breakthrough could happen at any time, in addition to economists at the ‘right schools’ or right financial sector firms, there are government officials with sufficient credentials to lead the breakthrough, including the head of the CBO and OMB, the Treasury Secretary and Fed Chairman, as well as former Fed officials, particularly from monetary operations.

Unfortunately Treasury Secretary Geithner, a potential hero due to the celebrity of his office, and the rest of the G20 are acting out the deficit hawk position, acting as if they do indeed believe the US has run out of money, is dependent on its creditors, and could be the next Greece. They speak as if they have no idea that the euro nations operate within a unique institutional structure that puts them in a ‘revenue constrained’ financial position similar to the US States, but with nothing equivalent to the US Treasury to run the countercyclical deficits for them. They speak as if they have no idea that the US, UK, Japan, and others with ‘normal’ central governments taxes function to regulate aggregate demand, and not to raise revenue per se. They act as if they don’t realize they can immediately make the fiscal adjustments- cut taxes and/or increase government spending- that will restore aggregate demand, employment, and output. In short, they act as if they were all still on the gold standard, an institutional arrangement where indeed government spending was constrained by revenues, and, as a consequence, the world witnessed repetitive, devastating deflationary depressions, far worse than what we’ve seen so far in this cycle.

The results of unnecessarily allowing a universal lack of aggregate demand to persist are already tragic, and if policy continues along the line of this weekend’s G20 results no relief is in sight, and it could all get a whole lot worse.

7DIF and national security

Euro May Rise to $1.60 Due to Austerity: Economist

“a group of logistics officers at the Industrial College of the Armed Forces developed a national security strategy as a class exercise. Their No. 1 recommendation for maintaining U.S. global leadership was “restore fiscal responsibility.”

Sec. of Defense Gates also got involved. All of them seriously misinformed, and think “fiscal responsibility” equals strangling a growing economy with a fixed currency supply. It’s a crisis of misinformation. Logistics training obviously doesn’t prepare one for sound systems, operations, ecology or macroeconomics analysis. You have to wonder if they’ve all adopted the “Scorched Economy” security model from Peter-the-Not-so-Great.

New Obama security strategy hardens economic resolve

“If you owe all this money you become less independent in the broader sense because you have to worry about where you are going to raise the next loan,” he said