Tuesday, November 16, 2010

Myths about the Deficit, Part 1

The hot topic in economics at the moment is certainly the enormous size of the deficit. Unfortunately, many of our politicians and even major economists are mistaken or are intentionally misleading the public about government deficits. This is mostly because of their ideologies or from being stuck in the past when we were on the gold standard. It is important, then, to understand how government spending works so that you can be an informed voter and engage in helpful dialogue with others who are misinformed.

So I will embark on a multi-part series on myths about the deficit (based on Warren Mosler's book the 7 Deadly Innocent Frauds of Economic Policy). Please comment or ask questions if you have them! This has very important implications for our political economy and is something that is vastly misunderstood!

Myth #1) The government must tax or raise funds through borrowing in order to spend.

The government can spend as much as it wants. It can print the money, or more accurately, change the numbers in bank accounts to meet its obligations. If it owes China $50 billion dollars for whatever reason, it can give China $50 billion dollars, without taxing the public or financing it through bonds. All it does is give China $50 billion U.S. dollars worth of credit to either spend in the U.S. or convert it to another currency.

This doesn't mean the government can spend what it wants without consequence. Over-spending can cause inflation or depreciate the currency, but it WILL NOT GO BANKRUPT!

So why tax us if the government doesn’t need it to spend?

Taxes create an on-going need to get dollars in order to pay them. They are what give our currency value. Our currency is no longer backed, partially or fully, with gold. It is a purely fiat money system and the way it maintains value is by the government demanding it to meet tax liabilities. If you don’t pay the government your U.S. dollars, then you will be thrown into jail.

Taxes also reduce our aggregate demand, or reduce our ability to spend. This allows the government to spend without causing inflation. Think of the economy as a big department store full of all the goods and services we produce and offer for sale every year. All together we earn enough wages and income to buy all of what we produce. But the government wants to spend money, too, in order to provide defense, infrastructure, etc. If it does not tax us then there is more money to buy than there are goods to be bought, this excess demand pushes prices up so that spending equals income, a necessary accounting identity.

If the government taxes us and does not spend, the output will not all get sold and prices will drop due to a lack of demand. But along with prices, businesses will cut costs by cutting employment because they didn’t make as much as they expected.

So the government taxes us in order to maintain currency value and allow it to buy the goods and services the people want it to buy.

Put simply, the federal government doesn't ever have or not have any dollars; it just changes the numbers in the bank accounts. It is more of a scorekeeper than a vault of money.

So how does that apply to today? The government wants to cut deficits amidst an underemployed economy on the verge of deflation. In order to boost spending, the government should increase the deficit to make up for our lack of spending.

Now this is where ideology and preferences come in. If you prefer smaller government, then you should demand lower taxes to improve private sector spending. If, however, we save the tax cuts and do not spend them, then they are no good. If you prefer a bigger government, then you should demand more spending.

Again, inflation and currency depreciation are our only concerns with high government deficits! But at the moment inflation is not a threat and unemployment is still terribly high. If the currency depreciates we should see a rise in exports and a fall in imports, another boost to our aggregate demand.

To be sure, this is not my own “opinion” or anyone else's “opinion,” but how it actually works. Opinions and ideologies can get in the way or be used within this framework, but do not change how the system works.

For more on this topic see:


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