Tag Archives: Dean Baker

Baker on deficits

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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.

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Baker Critique

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CENTER FOR ECONOMIC AND POLICY RESEARCH
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Does Citigroup Need China?

By Dean Baker

Most of the economists and pundits who could not see an $8 trillion housing bubble are telling us that the United States desperately needs for the Chinese government to keep buying its debt. This crew of failed analysts argues that without the support of the Chinese government, interest rates in the United States will rise, choking off the recovery. In reality, the decision by China to stop buying U.S. government debt may not harm the economy’s recovery, but it could be devastating to the recovery efforts at Citigroup and other basket case banks.

The basic logic is simple. China’s central bank has been buying up huge amounts of dollar-based assets for the last decade. Their purchases include short and long-term government debt, mortgage backed securities, and, to a lesser extent, private assets.

The Chinese central bank’s purchases have two effects. First, they help to keep interest rates low. This supports economic growth by keeping down the interest rate on mortgages, car loans, and other borrowing that boosts demand.

Interest rates are lower than otherwise only if China’s maturity preference is longer than that of who would otherwise have the excess balances and buy treasury securities. And most of what they buy is probably short term and therefore has little influence on rates.

The other effect of China’s purchase of dollar-based assets is that it keeps down the value of its currency against the dollar. This is the famed currency “manipulation,” that draws frequent complaints from politicians. Of course, it is not exactly manipulation. China has an explicit policy of keeping down the value of its currency against the dollar. It is not buying up hundreds of billions of dollars of U.S. assets in the dark of night. It does it in broad daylight in order to keep its currency at the targeted rate.

Right. They keep their currency down to keep their domestic real wages low enough to be ‘competitive.’

Suppose China stopped buying up U.S. government debt. Interest rates in the U.S. would rise,

Very little, if any.

which would have some negative impact on growth.

Very small impact, if any.

Of course, the Fed could try to offset this rise in rates by simply buying more debt itself. It has already been buying debt and it could simply buy enough to replace the lost demand from China. This would leave interest rates largely unchanged.

Yes, any time the Fed wants tsy rates lower it can simply buy them in sufficient quantities to keep rates at their desired target rate.

Suppose that the Fed doesn’t intervene and lets interest rates rise.

A few basis points.

This will have some negative impact on growth,

Tiny

but there will also be a very positive side effect from China’s decision to stop buying dollars. The dollar would fall in value against China’s currency. This would make Chinese goods more expensive in the United States, leading U.S. consumers to purchases fewer imports from China and more domestically produced goods.

Yes, which reduces our standard of living.
Imports are real benefits, exports real costs.

A lower-valued dollar would also make our exports cheaper in China. That would allow us to export more to China.

Right, we work and produce goods and services but instead of consuming them domestically we send them to china for them to consume. We become the world’s slaves instead of China.

The net effect would be an improvement in our trade balance,

The number goes towards positive, but that’s not ‘improvement’ from a US standard of living point of view.

bringing back some of the 5.5 million jobs that we’ve lost in manufacturing over the last decade.

We can sustain domestic demand at full employment levels with fiscal policy, such that there is sufficient demand for us to buy all we produce plus whatever the rest of world wants to send us.

And fewer manufacturing jobs means people in the us are free to produce other real goods and services for domestic consumption. It’s all a matter of sustaining domestic demand with the right fiscal adjustments.

In fact, since nearly all economists agree that the current trade deficit can’t persist for long, China would be helping the country bring about a necessary adjustment if it stopped buying up dollars.

Its their loss and our gain. Why should we work to kill the goose that’s laying the golden eggs for us?

Even the rise in interest rates would have a positive effect since it would allow for the completion of the deflation of the housing bubble, with house prices finally settling back to their trend levels. This drop in house prices will be a painful adjustment, but there is no way to avoid it.

How about supporting incomes through a full payroll tax holiday, and a $500 per capita revenue distribution to the states, and a federally funded $8/hr job for anyone willing and able to work
To use an employed labor buffer stock rather than an unemployed labor buffer stock as a price anchor.

Bubbles cannot be sustained indefinitely and we are better off allowing the housing market to return to normal so we can get back to a path of sustainable growth.

Sustaining incomes on a moderate 3% growth path rather than the current -3% path personal income is now on will work wonders for stabilizing the housing markets, and fixing the banks as well from the bottom up, as the bad loan problem improves due to falling delinquencies. Instead, the govt has been using top down funding of the banks that has resulted in delinquencies continuing to rise.

While the decision of the Chinese to stop buying dollars might be good for the economy,

Only because we do not understand the monetary system sufficiently to know how to sustain domestic demand.

it is likely to be disastrous for Citigroup and the rest of the basket case banks. If interest rates rose, then the value of the government bonds they hold would plummet. If the interest rate on 10-year Treasury bonds goes from the current 3.5 percent to a still-low 4.5 percent, then the banks will have lost 8 percent on their holdings. At a 5.5 percent interest rate, a rate that would still be far below the average for the 90s, the loss would be 15 percent. Citi and the other basket cases could not endure these losses in their current financial state.

Only if they currently have a maturity mismatch, which is not permitted by regulation. Bank regulators and supervisors get ‘gap’ reports for the banks to make sure they aren’t taking that kind of interest rate risk. If they are it’s a violation that the regulators need to put an end to.

This could be why we see shrill pronouncements from the likes of the Washington Post editors, and other “experts” who couldn’t see an $8 trillion housing bubble, that we need the Chinese government to keep buying up our debt.

Not likely the reason they think we need China to buy our debt.

We absolutely do not need the Chinese government to keep buying U.S. debt and would almost certainly be better off if it stopped tomorrow. Citigroup and the other big banks do need the Chinese government to keep the money flowing if they are to have a chance of getting back on their feet.

‘Money flowing’ has nothing to do with interest rates. The fed can set the risk free rate at whatever level it wants to.

And we know where the sympathies of the Washington Post’s editors and other “experts” lie.

— This article was published on October 19, 2009 by the Guardian Unlimited [http://www.guardian.co.uk/commentisfree/cifamerica/2009/oct/19/china-us-economy-debt].

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Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy. He also has a blog on the American Prospect, “Beat the Press”, where he discusses the media’s coverage of economic issues.

The Center for Economic and Policy Research is an independent, nonpartisan think tank that was established to promote democratic debate on the most important economic and social issues that affect people’s lives. CEPR’s Advisory Board includes Nobel Laureate economists Robert Solow and Joseph Stiglitz; Janet Gornick, Professor at the CUNY Graduate Center and Director of the Luxembourg Income Study; Richard Freeman, Professor of Economics at Harvard University; and Eileen Appelbaum, Professor and Director of the Center for Women and Work at Rutgers University.


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