Response to "It's NOT the Deficit, Stupid" Questions

I was asked a few questions by a reader regarding my post "It's NOT the Deficit, Stupid".

Here are the questions and my responses:

Reader:

I read your blog post about the deficit, and I have a few questions. I get what you are saying about taxes and government spending. I also understand how politics play a hand in this. What I don't quite understand is how we got in this mess in the first place. I would assume that we have our current national debt because we spent more than we issued taxes for, correct? My next question is how does the government go about alleviating the debt it has? I know that the Clinton Administration had the government in the black for the first time since the depression. How would they have done it?

Me:

1) You say how we got in this "mess". The mess that we are in is not government debt, but a failing economy. and what I mean by that is that the economy is underproducing what it could produce. There is unemployment and underutilized capital resources.

2) We have what many think is HIGH government debt because of the deficits run over the preceding years. Clinton did indeed run a surplus which proved to be detrimental to the economy by in part causing the recession in 2001. Bush ran really high deficits to pay for wars and help the economy. Spending was increased on wars mainly and taxes were decreased, mainly to the rich. Before that, Reagan ran the highest deficits since World War II and increased the overall debt substantially. It is also noteworthy that during these high deficits, the economy did pretty well, even though I would argue Reagan's economics were very flawed, but that is for other reasons I won't get into right now.

Then the Great Recession hit. When that happened government “revenues” (again, a misleading term) plummeted because business and personal incomes plummeted. Spending also increased because of automatic stabilizers kicking in such as unemployment insurance. So in this case, a lot of the federal deficit was an automatic symptom of the downturn.

A couple of stimulus plans were also passed, one being mainly a bailout of big banks to save the financial system from ruin and causing a much worse recession. This too added to the deficit; and, remember, all the deficit is is “revenues” minus “expenditures” where revenues are paid taxes and expenditures are what the government buys. It is NOT a LACK or SHORTAGE of funds.

It is also important to note that when the federal deficit increased automatically and because of the stimulus state and local government spending decreased because they CANNOT spend more than they collect in tax revenues because they do not control the currency like the federal government does.

3) The reason our economy is failing is NOT because of deficits or federal debt. It is for many other reasons that I can’t get into now, but a lot of it has to do with the housing bubble , deregulation of banks, and even illegal actions or fraudulent loans by the banks.

4) the total federal debt reflects the amount of bonds that the private sector holds. This gets tricky to say in an easy to understand way but when the government spends the Fed changes numbers in bank accounts. The net result is an injection of reserves into the economy. The Fed, in order to keep the federal funds rate (that’s the interest rate that the news is always talking about when Bernanke and crew change or keep it the same) at the level they set, must sell bonds to the nongovernment sector in order to deplete the reserves that the government puts in. In other words, they sell bonds to prevent inflation and zero interest rates. So right now, the total outstanding debt is what the government promises to pay the bond holders at a future date. The government will have NO PROBLEM paying these debts. They are not insolvent. Paying these debts off puts reserves back into the economy as it is a form of government spending. To bring down the overall level of debt, the government would have to run a surplus as they did during Clinton’s administration. In other words, they would have to pay off more bonds than they sold. THIS WOULD NOT BE A GOOD THING TO DO IN OUR CURRENT STATE. We need higher deficits to get the economy back to full employment. Then we can talk about bringing down the deficits.

As a side note, it is also important to know that the federal debt IS the amount of savings (held in bonds) in the nongovernment sector. If we want to have a net savings in the nongovernment sector, the government necessarily has to have debt, it’s an accounting identity. Note, however, that part of this savings is held abroad, notably by the Chinese government. This isn’t a bad thing, it’s just the way it is. China cannot exercise any power over us because they hold a sizable portion of our debt. In part, it is their way of holding down their currency so that they can grow their exports further.