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.

Ryan's Budget Plan: A Path to Greater Income Inequality

Our society is convinced that government cuts must be made or at least that is our politicians' perception of what society is demanding (or mandating). I disagree that high debt or deficits are something to worry about right now. We cannot go bankrupt without voluntarily declaring it and deficits are too low to sustain a full employment economy.

Here is one person's take on the direction that Ryan's budget plan will take us:
Ryan's "Path to Prosperity" is a "Cruel Joke"

Inequality and The Great Stagnation

A good read from Jonathan Chait:

Inequality and The Great Stagnation

Are things improving?

Good insight from Brad DeLong and Mark Thoma:

Are Things Improving?

Dangers of Income Inequality

Here is a good article on income inequality from Joseph Stiglitz. It's only coincidence that I am posting so much from Stiglitz lately, I stumbled across this today looking at other blogs.

I think the dangers he presents are real and the arguments he makes valid. Some highlights:

It’s no use pretending that what has obviously happened has not in fact happened. The upper 1 percent of Americans are now taking in nearly a quarter of the nation’s income every year. In terms of wealth rather than income, the top 1 percent control 40 percent. Their lot in life has improved considerably. Twenty-five years ago, the corresponding figures were 12 percent and 33 percent.

While the top 1 percent have seen their incomes rise 18 percent over the past decade, those in the middle have actually seen their incomes fall. For men with only high-school degrees, the decline has been precipitous—12 percent in the last quarter-century alone. All the growth in recent decades—and more—has gone to those at the top. In terms of income equality, America lags behind any country in the old, ossified Europe that President George W. Bush used to deride.

Economists long ago tried to justify the vast inequalities that seemed so troubling in the mid-19th century—inequalities that are but a pale shadow of what we are seeing in America today. The justification they came up with was called “marginal-productivity theory.” In a nutshell, this theory associated higher incomes with higher productivity and a greater contribution to society. It is a theory that has always been cherished by the rich. Evidence for its validity, however, remains thin.

Those who have contributed great positive innovations to our society, from the pioneers of genetic understanding to the pioneers of the Information Age, have received a pittance compared with those responsible for the financial innovations that brought our global economy to the brink of ruin.

An economy in which most citizens are doing worse year after year—an economy like America’s—is not likely to do well over the long haul. There are several reasons for this.

First, growing inequality is the flip side of something else: shrinking opportunity.

Second, many of the distortions that lead to inequality—such as those associated with monopoly power and preferential tax treatment for special interests—undermine the efficiency of the economy.

Third, and perhaps most important, a modern economy requires “collective action”—it needs government to invest in infrastructure, education, and technology.

The top 1 percent may complain about the kind of government we have in America, but in truth they like it just fine: too gridlocked to re-distribute, too divided to do anything but lower taxes.

But one big part of the reason we have so much inequality is that the top 1 percent want it that way. The most obvious example involves tax policy. Lowering tax rates on capital gains, which is how the rich receive a large portion of their income, has given the wealthiest Americans close to a free ride.

Much of today’s inequality is due to manipulation of the financial system, enabled by changes in the rules that have been bought and paid for by the financial industry itself—one of its best investments ever.

Wealth begets power, which begets more wealth.

The personal and the political are today in perfect alignment. Virtually all U.S. senators, and most of the representatives in the House, are members of the top 1 percent when they arrive, are kept in office by money from the top 1 percent, and know that if they serve the top 1 percent well they will be rewarded by the top 1 percent when they leave office.

With youth unemployment in America at around 20 percent (and in some locations, and among some socio-demographic groups, at twice that); with one out of six Americans desiring a full-time job not able to get one; with one out of seven Americans on food stamps (and about the same number suffering from “food insecurity”)—given all this, there is ample evidence that something has blocked the vaunted “trickling down” from the top 1 percent to everyone else. All of this is having the predictable effect of creating alienation.

Alexis de Tocqueville once described what he saw as a chief part of the peculiar genius of American society—something he called “self-interest properly understood.” The last two words were the key. Everyone possesses self-interest in a narrow sense: I want what’s good for me right now! Self-interest “properly understood” is different. It means appreciating that paying attention to everyone else’s self-interest—in other words, the common welfare—is in fact a precondition for one’s own ultimate well-being. Tocqueville was not suggesting that there was anything noble or idealistic about this outlook—in fact, he was suggesting the opposite. It was a mark of American pragmatism. Those canny Americans understood a basic fact: looking out for the other guy isn’t just good for the soul—it’s good for business.

The top 1 percent have the best houses, the best educations, the best doctors, and the best lifestyles, but there is one thing that money doesn’t seem to have bought: an understanding that their fate is bound up with how the other 99 percent live. Throughout history, this is something that the top 1 percent eventually do learn. Too late.

The economy and the society as a whole become more and more unstable as income inequality gets worse and worse. I can't stress enough how important it is that this issue be addressed, yet I get the feeling that nothing will be done and that it may already be too late.

The government's role in society is to pursue and provide for the common good of the society for which it serves. Yet, lately, the government has served the pockets of the rich very well, while the common good is suffering.

Good Policy Suggestions

Here are some are good policy ideas to improve the efficiency and equity of our economy from Joseph Stiglitz, a Nobel prize economist, professor at Columbia University, and former chief economist of the World Bank.

Below are some selected quotes and paraphrases from this paper by Stiglitz published on December 2, 2010 through the Roosevelt Institute, which was focused on the political problem of reducing the deficit. I do not believe that the deficit is the issue, but rather the long term overall situation of the economy and Stiglitz seems to agree though this paper has as its explicit goal improving the economy through reducing the deficit, though I believe his implicit goal is not so much concerned with deficits as it is with overall economic well-being. I hope the quotes and paraphrases will illustrate what I mean. I added emphasis to the points I thought were most striking or important and I believe these ideas are largely in accord with Catholic Social Teaching, particularly the goals of social justice and economic welfare for the society as a whole.

Politically the task of deficit reduction is enormously difficult.

At the head of the list of reforms are measures which increase both efficiency and equity.

Given the enormous increase in inequality that has occurred in the U.S. over the past three decades, any measure that harms those at the bottom should also be unacceptable.

What matters is not the deficit itself or the short-run national debt, but long-run levels of the national debt. The single-minded focus on deficits and short-run debt is thus fundamentally misguided.

There is no magic number that represents the appropriate size of the federal government.

A larger government, but one focused on investments, could be associated with a smaller deficit.

This paper is not about political compromises, [but about] principles of efficiency and equity.

These first ideas in particular are based on the premise that what is important is the long-run national debt, not the short-run deficit. Just like it may pay for a business to borrow in order to increase long-run profitability.

Public investment can yield high returns.

Three factors contributing to opportune investments today: 1) there has been underinvestment for years, 2) the borrowing interest rate is at record low levels, and 3) the economy is operating significantly below capacity.

Historically, public investments in education, technology, and infrastructure have yielded returns that are in excess of 7.5%.

Corporate Welfare

Corporate welfare consists of billions of dollars to enrich the coffers of corporations.

The net beneficiaries of such corporate welfare are by and large wealthy Americans.

Two categories in general need to be addressed: subsidies to agriculture and agribusiness and subsidies to producers of fossil fuels.

Most of the money of agricultural programs goes to corporations and Americans who are better off than average.

There are easy fixes, e.g., by limiting the benefits to those whose income is below $100,000 and limiting payments to, say, at most $100,000 per farm.

[Particularly bad are] the excessive payments to the pharmaceutical companies under the provisions of the Medicare bill, which restricted the government’s ability to bargain with them on prices.

Efficient auctioning of the rights to use natural resources can lead to greater efficiency.

Taxation

Our tax system is neither fair nor efficient.

Much corporate welfare takes the form of special treatment within the tax code.

A small increase in the tax rate on the top 1%, say 5% of their income, would generate revenues equal to between $1 and $1.5 trillion. Currently, most of these individuals pay effective tax rates that are far below the “official” rates because of their ability to take advantage of tax preferences and loopholes. Eliminating these tax preferences and loopholes would go a long way towards achieving this limited increase in taxation.

One proposal that has been widely discussed is to tax all forms of income the same, i.e., eliminate the preferential treatment of dividends and capital gains, the benefits of which go disproportionately to upper income Americans.

In the end, the special treatment afforded to dividends and capital gains did not have the benefits promised: instead of household savings increasing, the savings rate plummeted to new lows after the enactment of the Bush tax cuts.

There is moreover no justification for taxing those who work hard to earn a living at a higher rate than those who derive their income from speculation.

Rather than an across the board reduction in the corporate income tax, far better would be a tax reform that would encourage investments in jobs in the United States, and that would encourage investment in research and development.

There is a class of taxes that actually increases economic efficiency—taxes which discourage activities which generate negative externalities sometimes referred to as Pigouvian taxes.

The repeated bailouts of banks have led to a distorted and inefficient economy. Taxes can be used both to undo these distortions and contribute to deficit reduction.

Probably nothing did more to enhance the sense of injustice around the world than the receipt of huge bonuses by those responsible for the economic crisis, even as the banks were being bailed out by taxpayers who bore the brunt of the costs of the banks’ misdeeds.

A well-designed bonus tax could thus encourage incentive structures that align behavior of those in the financial sector with the long term interest of society, contribute to a broader sense of societal fairness, and simultaneously contribute to deficit reduction.

Among economists there is a broad agreement that the repeated bailouts have led to a problem of moral hazard with excessive risk taking and an excessively large financial sector.

The Obama administration at one point talked about a tax based on leverage and size, designed to discourage excessive leverage and size.

More Efficient Expenditure

There are some areas of public expenditures where the objectives of the government programs could almost surely be achieved at lower costs.

The single most important area of discretionary expenditures is military. Americans could obtain more security at lower cost.

We spend billions on weapons systems that don’t work against enemies that don’t exist. With America’s military spending approximately equal to that of the rest of the world combined, it is clear that there is a lack of balance.

America’s moral authority is more important than its military power.

Military expenditures do not contribute to our economic strength.

Direct conflicts impose costs that extend decades into the future, through health care and disability costs for the returning vets.

Final Points

Deficit reduction, it should be remembered, is not an end in itself, but a means to other objectives. If done the wrong way, our growth can be impaired, our society can become more divided, and the capacity of both our country and our government to deal with the challenges facing it can be impaired.

The reason that we have the myriad of the distortions and inequities that we have identified is because of the influence of special interest groups who so far at least, have been willing to sacrifice the national interest to their own.

Other data:

The effective tax rate was 23% for the top 1% and 21% for the top 5%, markedly lower than the legislated rate of 35%.

Median income has declined by some 5% over the past decade and was in decline before the recession.

Poverty has increased from 11.9% in 1999 to 14.3% in 2009.

The upper 1% of Americans accounted for an average of some 22% of the nation’s taxed income during 2004-08.

65% of the income growth during the Bush expansion was captured by the top 1% of families.