I want to explain how things work, not what you should believe.
by John Harvey Forbes
I could hear Meet the Press on in the background at my house on Sunday and the reporters were discussing various means of reducing the budget deficit. I didn’t bother to sit down and listen, however, because I knew that none of it made any sense. All were based on the same false premise: federal government deficits represent a burden on the private sector.
They do not. Consider the following:
1. Public sector deficits are private sector surpluses. I try to be very careful about making proclamations of “truth.” Science done properly assumes that every proposition is falsifiable and that we must remain skeptical, especially of the views we have adopted ourselves. But this is about as close as you get to fact: when the public sector spends in deficit, it is by definition a surplus for the private sector. If the government spends $500 more than it taxes, then it must be true that the private sector earned $500 more than it was taxed. Period. This is an inescapable accounting identity.
A logical extension of this is that public sector deficit reduction = private sector income reduction. Imagine if politicians and policy makers worded it this way. Take, for example, these excerpts from the 2013 State of the Union address (substituted text in italics):
Over the last few years, both parties have worked together to reduceprivate sector income by more than $2.5 trillion — mostly through spending cuts, but also by raising tax rates on the wealthiest 1 percent of Americans.
In 2011, Congress passed a law saying that if both parties couldn’t agree on a plan to reach our private sector income reduction goal, about a trillion dollars’ worth of budget cuts would automatically go into effect this year.
Let me repeat — nothing I’m proposing tonight should increase private sector income by a single dime.
Now is our best chance for bipartisan, comprehensive tax reform that encourages job creation and helps bring down private sector income. (Applause.)
I suspect that none of these statements would have generated a great deal of applause, yet they are every bit as accurate–and more relevant–than the originals.
2. The US can never be forced to default on debt denominated in its own currency. One might reasonably ask, even if the above is true, won’t an increasing debt level leave us in danger of national default? No, it will never do so as long as the debt is in a money we are permitted to issue. This should be the least controversial statement one can make about the debt, yet I often find that it is the most! I won’t pursue it here, but for further confirmation (including statements from the Federal Reserve Bank of St. Louis and a former Fed chair), see this blog entry: It Is Impossible For The US To Default.
Bottom line: an increasing debt level does not put us in danger of default.
3. Deficit spending is not inherently inflationary. Another common worry that issuing more currency to finance deficit spending (which is basically what we do, though in a roundabout manner) could be inflationary. This is true, it could be. But the circumstances under which that would occur are also those where we have the least incentive to deficit spend, i.e., at very low levels of unemployment. Only during WWII have we done this. For three consecutive years during the war, joblessness was below 2%, and yet we continued to run huge deficits to finance the war effort. Did this drive prices higher? Absolutely, and it was only because of wage and price controls and rationing that it was not worse. Running such large deficits was clearly ill-advised from an economic standpoint because it raised demand when supply could not go any higher; but our goal was political and so we saw this as a necessary evil.
Contrast that with high levels of deficit spending when there is a lot of unemployment. Two cases in point are the Reagan and Obama administrations. These two are by far the leaders in debt growth (measured as a percentage of GDP) in the post-war period, with the rate under Reagan being just over twice as high as Obama’s. Average inflation under Reagan was 4.7%. While this is greater than the 1948-2013 average of 3.6%, it belies the fact that when his deficits were largest (his last six years in office), inflation was exactly equal to that rate. To repeat, the largest peacetime increase in debt in history led to average inflation. Meanwhile, under Obama inflation has averaged 1.6%. That these two were in office during all or part of the two worst recessions since the Great Depression is not a coincidence.
There is nothing inherently inflationary about deficit spending and when it is most likely to be inflationary, we shouldn’t be doing it anyway.
4. The debt to China has nothing to do with the budget deficit. The last objection one often hears is that, because they own increasing volumes of our national debt, we are ceding our economic independence to China. First and foremost, the debt to China has nothing to do with the budget deficit and everything to do with the trade deficit. They are net purchasers of our assets because every year we buy more goods and services from them than they buy from us. That leaves them with dollars that they do not want to spend yet. So, they invest them. This would have been true even if the US budget had been surplus. Our debt to them would have been identical, except that they might have purchased shares of private companies (a much more sensitive political issue, by the way) instead of Treasury Bills. In any event, however, the federal government’s budget balance has nothing to do with the debt to China. Furthermore, if we wished to pay it back overnight, we could do so. But, China doesn’t want the dollars–they already had those–they want the interest-bearing assets.
In short, there is absolutely no reason to be discussing deficit/private sector income reduction with unemployment at 6.6%. We are a long way from full employment and firms and consumers remain rightly hesitant to increase their spending sufficiently to address this problem. Yet, while the government is in a perfect position to do so, both parties’ ignorance of economics and accounting has served as a major roadblock in generating jobs and income in the private sector. This is not to say that all deficits are created equal. There are most certainly good and bad ways to spend, just as there are good and bad ways to administer first aid to an accident victim. But, that the victim needs first aid is not an open question.
One day I hope to live in an economically literate world where the reporters I overhear on Meet the Press are discussing means of lowering unemployment–the real problem that has real consequences for real people–and not the deficit. Until then, I’ll just change the channel.
John Harvey is professor of Economics at Texas Christian University, areas of specialty are international economics (particularly exchange rates), macroeconomics, history of economics, and contemporary schools of thought.