Consider this for a moment: As of January 2011, we had 13.9 million unemployed people in the United States (and note that it takes very little to count as "employed"). Recommended cuts in the federal budget have ranged from tens of billions to hundreds of billions of dollars. In practice, what do these represent? They are at the very least a reduction in the wages of Americans who are currently working, if not outright job loss. This makes them functionally equivalent to a tax increase. Ask yourself this question: How would raising taxes by tens to hundreds of billions of dollars right now lower unemployment and speed recovery? You're right, it wouldn't. In fact, it's not difficult to see that it would make it much worse. Unemployment is not reduced by cutting incomes and destroying more jobs. But that's the policy currently being pursued with great enthusiasm in Washington, and the two parties differ only in degree. We are on the road to economic suicide. The gun is loaded, cocked and aimed squarely at the American worker.
The economic illogic of these recommendations runs deep. In the most recent State of the Union address, President Obama likened the federal budget to that of a household. This is a false analogy, the application of which has led us to believe that cutting government expenditures in the midst of the second-worst contraction is economic history is a good idea. It is an invalid comparison on at least two levels.
First, households do not print their own money. If you want to buy a big-screen TV and don't have the ready cash, you are forced to find someone willing to loan you the funds. You could try issuing your own currency and bringing it to the store, but I suspect you would not find yourself leaving with a TV (if you do, please let me know where you shop!). The federal government can do this, however. There is no logical reason it needs to "borrow" money from anyone (least of all China, since dollar bills are one of the few things we still make in this country!). The idea that we need to borrow to finance federal budget deficits is a fiction or, as Paul Samuelson called it, a myth. We use it to indirectly constrain Washington in order to make it consider its choices more carefully. But there is no economic logic to it, only political. The Treasury could finance any project by issuing debt that the Federal Reserve then immediately purchased with brand-new cash (though they are presently not permitted to do this, they can come pretty close), meaning that not a single penny is taxed or borrowed from U.S. citizens or companies, China or anywhere else.
Nor is this inflationary. If it were, first of all, simply having borrowed the money from China would have already caused inflation. Second, inflation is a far more complex phenomenon than is allowed for in the popular press or in introductory economics courses. The way a modern financial system works, simply creating money does not lead to price increases in the same way it might in a world where gold was the only currency, for example. In the latter, discoveries of gold would increase the money supply regardless of people's wishes.
If (and this is a very important "if") the economy were already operating at full capacity, with all willing workers employed, then, indeed, as it spent the newfound gold, inflation would follow, since no more goods or services could be produced. However, first, we are not at full employment (far from it), so a discovery of gold like this would actually have the effect of increasing production and employment, and second, our monetary system doesn't work that way in the first place. The primary tool by which our central bank introduces new money into the economy is the purchase of government debt from the public. This is a voluntary transaction, in the sense that no one who owns that debt is forced to sell it. Thus, it is impossible to create a situation analogous to the discovery of gold mentioned before. Money doesn't get dumped on us and thereby cause inflation. Instead, it is created when agents make portfolio management decisions.
To make this more clear, consider a brief example of how inflation really works. Recall the worst episode of inflation in U.S. economic history, that of the 1970s and early 1980s. What happened, of course, was that the OPEC oil cartel cut supply in order to drive up prices. The increases went well beyond oil, because of the central role played by energy in our economy. The money supply most certainly did increase, but in response to these events and not as a causal factor. Businesses (especially banks) and households freely offered to sell Treasury bills to get the cash they needed to pay the higher prices caused by the OPEC oil embargo. The Federal Reserve, recognizing that these were legitimate and even desperate needs, accommodated by buying them, and the money supply rose.
This is not to say that increases in the money supply cannot cause inflation. However, not only are the conditions under which they would do so uncommon, but one of the key ones would be that we were already operating at or near full employment. That hardly describes where we are today. Creating new money--which we do all the time, of course, as the money supply is constantly growing--is not in and of itself inflationary, particularly in a time of high unemployment.
Thus, the federal government's budget is unlike your household one, because it issues its own currency. It can fund spending without taxes or borrowing, and without causing inflation. Those who argue otherwise are either operating with economic models developed in the 18th or 19th century or they are buying into President Obama's State of the Union address analogy (or have an ulterior motive). But it simply isn't true.
The second fundamental difference between a household budget and that of the federal government is that the former does not have the means or responsibility to stimulate the macroeconomy to the point that it employs all willing workers. This is an absolutely key point that has been almost entirely ignored. As technology allows us to become increasingly productive, it creates a cruel irony. On the one hand, we develop the capacity to produce more sophisticated and efficient products for all of us to enjoy. On the other, we are able to do so by employing fewer and fewer people. Those without jobs, even though they are willing to work, must go without despite the fact that we have the capacity to meet their demand. If the government did not act to supplement this, then we would find ourselves in a constant state of poverty amid the capacity for plenty--just as we did in the Great Depression (and as we do to a lesser extent right now).
The market can't correct this on its own. We have no right to expect entrepreneurs to hire more workers than they need or consumers to buy more televisions than they want. Entrepreneurs' goal is to find low-cost ways to satisfy consumer demand, not generate a jobs for all those who want one.
The federal government, however, is in a perfect position to do this, and when it does so it is a net gain for everyone. Say it takes an unemployed worker and makes him a soldier. As already explained, paying him requires neither a borrowing nor additional taxation (indeed, the latter would be counterproductive, just as cutting expenditures is right now). The government could create new money and the result would be an increase in income for everyone, including those in the private sector. Those who had already been employed would give up nothing. They'd be able to enjoy the same number of goods and services as before, since we were never at full capacity. Plus, they'd now have all that and protection against foreign aggression. The soldier would obviously be better off, since he'd now have money in his pocket and be able to buy the goods and services society was always able to produce. And entrepreneurs would get higher sales, which they obviously like, and might even find it necessary to hire more workers to meet the new demand. All net gains, every single one, because the economy was at less than full employment--a place where the market system tends to leave us.
A secondary lesson here is that not only can the federal government spend in deficit forever, but it must do so if the private sector is to reach its full potential. Deficits raise the level of private wealth while surpluses, representing as they do an excess of government taxation over spending, necessarily drain wealth from private citizens and firms. It is no coincidence that the Clinton surpluses coincided with massive increases in private-sector debt. It's simple math. The government is not a household, and you cannot apply the same logic without disastrous consequences. We went through this same debate in the 1930s, and it was only settled by Pearl Harbor, when suddenly deficits that put our present one to shame were viewed as absolutely right and just--and the economy hardly collapsed then or in the postwar era.
There is also a great deal of confusion regarding the role of China in financing the national debt. First, as already mentioned, there was never any economic reason to sell Treasury bills to China. If China and everyone else on the planet decided tomorrow that they didn't want any more, there is no reason why that must act as a constraint on federal spending. We could simply sell the debt directly to the Federal Reserve for the necessary cash (as stated earlier, that's not strictly permitted under current rules, but there's no economic reason not to do it).
Second, if China were to suddenly want to "cash out," which for a variety of reasons it is exceedingly unlikely to do, we could easily pay it back with the dollars that we are legally permitted to create. It was already explained above why this is not inflationary, besides which the new money would be in China. And if it caused the dollar to depreciate (which is far from a certainty), then that would increase our exports and decrease our imports--one of the many reasons China would be reluctant to do it! But third and most fundamentally, the debt owned by China is a function of our trade deficit with that country, not of the federal budget deficit. Even if the latter were in surplus, we would still owe as much to China as we do right now. When we import more from China than we export to it, it ends up with a surplus of cash.
For example, in December of 2010, we sold roughly $10 billion in goods and services to China while purchasing $30 billion. This gave the country net earnings of $20 billion. Because it had already bought all the U.S. goods and services it wanted, it used the earnings to buy U.S. financial assets. The fact that we had a budget deficit only served to make a particular class of assets abundantly available. Had the U.S. budget been in surplus and we weren't selling new Treasury bills, China would have purchased something else, perhaps the stock of U.S. companies (which might have given it more real control than people assume it has now). As it stands, we can solve our China debt "problem" overnight by buying that debt back with new cash. There is absolutely no reason to do this, but we could. Of course, China would then need to buy something else with those dollars, presumably U.S. private-sector assets.
To reiterate, debt to China, private or public, is a function of the trade deficit and has absolutely nothing directly to do with the budget deficit. It will not go away if we balance the budget; it will only change forms. Do we want China owning Treasury bills or
In conclusion, I am not saying that allowing the government to spend at will may not lead to abuses. As suggested above, the balanced-budget myth was perpetuated by the likes of Paul Samuelson for a reason: It was meant to act as an indirect constraint on federal power. That's all well and good when the myth doesn't cause more harm than good. In order to keep my children in bed every night, I could tell them that monsters congregate in their rooms after dark. But what would happen if there were a fire and my children refused to leave? The result would be horrifying. We have a fire right now, and, jokes about politicians aside, we aren't dealing with children. If we need a means of corralling power, and we certainly do in both the private and public sectors, then let it be accomplished in a way that deals honestly and pragmatically with the real problem. The lives of almost 14 million people and their families depend on this. Perhaps the cruelest irony is that of all the problems we face today, this is the easiest one to solve--yet we are doing our very best to make it much, much worse.
John T. Harvey is a professor of economics at Texas Christian University.
Thanks to Forbes
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