Fiscal Cliff Notes

Some of my (somewhat well-educated) thoughts on the fiscal cliff:

1) The fiscal cliff is NOT the point at which the government runs out of money. Somehow this has become the widespread notion of what the Fiscal Cliff is, descriptively. Remember, the issuer of a currency cannot run out of that currency. The U.S. government, as issuer of the dollar cannot run out of dollars.

2) The fiscal cliff IS the point at which spending cuts kick in and tax cuts expire so that the deficit closes. That is, (G - T) becomes smaller. Every economist understands that this will hurt the economy because it contracts overall spending in the economy. GDP = C + I + G + (X-M). So if Taxes go up, our spending (Consumption and Investment) will go down and if government spending goes down, overall GDP will drop unless somehow we miraculously become a large net exporting nation.

3) Knowing this, we still think we have to shrink the deficit. I detailed this a couple of weeks ago, so I recommend reading that piece. IF we let the fiscal cliff happen, the economy will shrink quickly. If we reach a deal, the economy will sputter and will likely fall some if not a lot--it depends on the magnitude of the deal.

4) We need a larger deficit! This can be accomplished through spending increases or tax cuts, but the only way to actually shrink the deficit is to increase GDP. The private sector is still deleveraging, the foreign sector--our trading partners--is in poor shape, and so the only institution that can help is the government. Otherwise we're in for a long, slow deleveraging period--see The Great Depression. This is needless because the government has policy tools to prevent it, and it doesn't necessarily have to mean a concentration of government power.

5) What we spend money on matters! Some spending has a higher multiplier effect or employs more workers. Much spending is extremely wasteful and so wouldn't do much to help our society or our economy. All spending will benefit some more than others. Some spending is immoral. We need to make these decisions as a society in the political arena, but note these decisions have economic effects--see my most recent post on this.

6) We have a particular duty to look out for those left behind or trampled on by the system. We can do this personally and through institutions--including Churches, non-profit organizations, local governments, and the federal government. All have advantages and disadvantages, but all are needed according to the principle of subsidiarity, which is not a limiting principle (thinking of it solely as a principle that limits the size of government), but is rather a cooperative principle (thinking of it in terms of all institutions of all sizes working together to accomplish the common good).

Demand Signals

Economics, in some sense, is the study of choices. The study of how your choices and my choices affect economic variables and economic outcomes. This is, in part, why economics cannot be completely separated from other social science disciplines concerned with human behavior, such as history, psychology, sociology, political science, and anthropology.

One advantage of capitalist economies over other modes of production is the freedom it gives to its citizens to participate in economic life--to make choices mostly free from constraints. This freedom isn't without necessary prerequisites, qualifications, or undesirable results, however.

Instead of being organized around a central planner, our economy is organized around 'demand signals'. Production decisions aren't made by the state, but by producers usually thought of as capitalists but are really more likely small business owners, CEOs, Boards of governors, etc. They obtain funds, at least initially, from banks through loans or from the public through sales of stock. In order to obtain those funds, they must have some prospects for selling their proposed product. This puts production decisions largely in the hands of bankers, who estimate the expected rate of return on the proposed investment, or stockbrokers who do the same. For the former it means getting the loan paid back, the latter a rise in the share price.

Yet both are looking at expected rate of return, a hard to gauge variable that because it is based on uncertain expectations of the future depends more on current sales or current demand. This is where our choices come in, or our demand signals.

You see, we demand with our money and the purchase of a good or service sends a signal to the producer or to the bankers making lending decisions. That signal is usually to invest more in that product or service--to increase investment, or to raise the price of that good or service to obtain more profits with which they too use to purchase goods and services to send signals to their suppliers. It is this interconnected web of demand signals using paper money (or money from bank accounts) that organizes real output in our economy.

We don't have a central organizer or planner who has to guess how much to produce, or to guess how much we want or need of any one product or service. We send signals through 'the market' and 'it' organizes production along those signals.

There are many implication or conclusions to be drawn from this.

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:

http://moslereconomics.com/2009/12/10/7-deadly-innocent-frauds/
http://neweconomicperspectives.blogspot.com/2010/11/keep-deficit-ditch-doves.html
http://tomgreenthumb.tumblr.com/