Deficit Spending

Michael,

I had a comment about your point that "the most common complaint about deficits is that by spending money we don't have we're just deferring payments to the future and compounding interest, thereby ensuring we'll have to pay more later than we would now." This is a perfectly valid point - by using deficit financing, the public incurs interest charges that it wouldn't otherwise incur. The counterpoint that people tend to look over is that the alternative to deficit spending is increased taxes, and that by deficit spending, we are able to defer paying our taxes and gain interest on the money saved on taxes. On balance, the increased debt from interest on borrowed money and the increased wealth from interest on saved taxes balance out. The hoopla about deficits is relatively unimportant and serves to distract us from the substantative issue: the size of government spending.

There's a good analogy about this in the book "The Armchair Economist", by Steven Landsburg. I highly recommend it. He says: suppose that you hire an agent to do your shopping for you. He gets to decide how much to spend and how to finance it. Let's suppose that he decides to spend $100. He can finance that purchase by:
1) Withdrawing $100 from your bank account.
2) Charge it to your credit card and pay off the debt a year in the future, at $110. (assuming an interest rate of 10%)
3) Charge it with no intention of ever paying off the debt. He will then pay $10 a year in interest charges.

Any of these schemes will deplete your bank account by the exact same amount of liquid assets. Let's say you've got $1000 in the bank now. A year in the future, that would rise to $1100. Under the first plan, your bank account would fall to $900, and in a year would earn another $90. So after a year, your account would be depleted $110. Under the second plan, you'd earn $100 in interest, but then have to pay $110 on your debt. Under the third plan, you'd have to deduct $10 next year to pay the interest on your debt, and also set aside a fund of $100 to earn that interest for you every year. Under every plan, you have the same usable assets.

Deficit financing doesn't really matter.

Brett

I'm not an economist, but I think that you are pretty much correct under a simple scenario.

However, a few points should be made...at some point, the US government decided to run deficits. It's come to a point now that about 10-20 cents of tax is devoted to paying off the interest. In effect, taxes are higher by that much than they could have been had previous governments raised their taxes instead of incurring debt. At this point though, yes, if we keep the rate of deficit growth lower than growth of GDP, the interest payments as a percentage of GDP will remain constant or fall, all other things equal (especially interest rates).

The other point is that what I just said isn't completely true nor Brett's point. The government taxes things at different rates. Salary is taxed at one rate, dividends and capital gains at other rates. There are estate taxes which only come into play at certain times. So 3% growth in GDP, doesn't necessarily equate a 3% growth in government revenue.

The counterpoint that people tend to look over is that the alternative to deficit spending is increased taxes, and that by deficit spending, we are able to defer paying our taxes and gain interest on the money saved on taxes.

In a perfect world, yes. However, it all depends on how people use that money that they "saved" from deficit spending. If they buy government debt, than the rates of return are the same and the government gets the added bonus of taxing your interest earnings. If they invest in something that earns a higher rate of interest, then they are better off, but the government might not see the full benefit if those earnings are taxed at a lower rate than your salary.

If people spend the money on domestically produced items then there are spinoff benefits which may or may not even out. If everyone used their windfall to go on a trip overseas, then much of the economic benefit is lost to us.

The problem is not the deficits-- that is mere borrowing, but what the deficit is to be used for and how you intend to pay for it. Deficits during times of war are common; the assumption is that it is better to risk a depression later than to lose a war now.

And too, deficits are acceptible to climb out of governmental mismanagement. As Supreme court Justice Felix Frankfurter once remarked, "the power to tax is the power to destroy," A government can tax so highly thst it destroys its economy, Rich people, during third century Rome, fled to the wilds of Gaul to avoid having their wealth expropriated.

On the wrong side of the "Laffer Curve" a tax increase will decrease the tax revenue obtained, so running a temporary deficit to decrease tax rates will stimulate the economy and produce higher revenues later. This is the problem we experienced during the last recession. Consumers were spending, but business people were taking no risks because the rewards for doing so were too low. Bush'e tax breaks did cause the economy to take off.

Running deficits to finance governmental programs is dangerous, because no way is provided to pay them off. This action must lead to higher taxes which will depress the economy or the debt must be monitized.

And monitizing the debt by increasing the national debt is the problem. This destorts the economy by making loans artificially cheap which tempts the bankers into making questionable loans. It causes a general price increase to adjust for the increase in the money supply. It acts as a hidden tax on savings and retirement accounts, because the general price increase slowly destroys purchacing power. But worse, it destroys confidence in the value of money. Runs on banks become runs on all banks. Money can become not worth the paper it is printed on.

Deficit financing is a dangerous occupation. The Federal Reserve avoids a permanent
correction-- a big depression by giving us small one's every so often. It is a bit like how the "hair of the dog" cures a hangover. It is a temporary fix though. One that never gets you sober. The effects of past hits of whisky soon require another hit. Or you start putting up with withdrawal symptoms.

So, we live with stagflation. The economy is never really healthy; it is either a little drunk or feeling woosy. The question is how we are ever going to get the country off this monitary bender. Both political parties want to avoid a depression, But, only a depression where we allow prices and wages to fall to adjust to reality will get us healthy again.

The deficits are unlikely to push us into a runaway inflation or depression at this stage of the business cycle, but you never know. The problem is that both parties need money to buy votes. So, the problem never ends, but life can be funny. Something, another big act of terror perhaps, might act to end the game for us.

LW: You wrote: Running deficits to finance governmental programs is dangerous, because no way is provided to pay them off. This action must lead to higher taxes which will depress the economy or the debt must be monitized.

I'm not sure I believe that, since the economy can grow fast enough on its own to compensate for some level of deficit spending, even if the borrowed money isn't spent productively.

Also, the boom/bust cycle is good for the economy overall. I don't think it's possible to get rid of it anyway. When the economy turns south companies lay off inefficient workers and productivity improves -- there's less incentive for productivity gains in a boom economy when everything is growing already. Then when the boom comes businesses eventually start to expand again, grow, and become less efficient (but still profitable). It's a beneficial cycle, creative destruction.

"LW: You wrote: Running deficits to finance governmental programs is dangerous, ... This action must lead to higher taxes which will depress the economy or the debt must be monetized.

I'm not sure I believe that, since the economy can grow fast enough on its own to compensate for some level of deficit spending, even if the borrowed money isn't spent productively."

Michael, the economy can''t grow fast enough to overcome the waste that is produced. Much of the growth during the boom times is illusionary; later recessions wipe it out. Again, it is not the deficit that matters; it is how you pay for them.

"Also, the boom/bust cycle is good for the economy overall. I don't think it's possible to get rid of it anyway."

I suggest that you read a little history. Paul Johnson''s, "A History of the American People" is quite good. America didn't have this boom /bust cycle during the Nineteenth Century. We would have periodic Banking Panics which were short lived-- the 1921 crash that washed out the debt and waste of financing World War One lasted nine months. Both wages and prices fell, and prices fell more than wages. Since employers could cut their costs, they could afford to keep their best employees. Unemployment was low; only unproductive, uneconomical and inflexible companies were wiped out. The laid off workers soon found new jobs producing goods and services that the consumers wanted.

President Hoover's massive intervention in the economy in 1929 extended the banking panic caused by lending Britain $50 Billion to avoid lowering the value of the Pound for a time. Roosevelt's intervention of the "New Deal" merely dug the same hole bigger and deeper.

"When the economy turns south companies lay off inefficient workers and productivity improves -- there's less incentive for productivity gains in a boom economy when everything is growing already. Then when the boom comes businesses eventually start to expand again, grow, and become less efficient (but still profitable). It's a beneficial cycle, creative destruction."

The American economy is constantly using Creative Destruction; it is part of what is counter balancing the effects of deficit financing. Enormous gains in productivity are necessary just to keep prices stable. The government can always increase the money supply faster than companies can innovate.

The question about booms is "are they real?" Is the Boom due to expanding the economy in new directions? Is technology cutting the costs of production and causing real gains? Are unexploited resources being utilized? Are the customers needs being filled in better ways? Or is it all a fraud caused by easy money? If it is easy money then a bust is sure to follow.

The Banking Panics of the Nineteenth Century were caused by easy money too, but we didn't have a Federal Reserve then to cause intentionally monetary inflation. The value of the dollar floated. If people exuberantly invested in unproductive industries, railroads or cotton, for example, then reality eventually set in. American's disliked the economic disruption which followed, but didn't have the means to put off the consequences. We couldn't prop up unhealthy industries. We couldn't overspend and push the cost onto our children. We couldn't afford the Welfare State.

The question is "Can America dig Itself out of the economic hole we have created?" America's economy is healthy only in relation to the rest of the world. Social Democracy and managed economies produce little growth. High taxes and inflation decrease initiative. Our economy is number one only because it has so little competition.

LW: Michael, the economy can''t grow fast enough to overcome the waste that is produced. Much of the growth during the boom times is illusionary; later recessions wipe it out. Again, it is not the deficit that matters; it is how you pay for them.

Nonsense. The economy has been growing at an average of 2%-3% annually for several millenia.

There have always been cycles of plenty followed by want, all throughout history. They can take different forms based on our economic and monetary systems, but the overall paradigm is inescapable.

The Fed smooths out the bumps in the road, and has done quite a good job as financial theory has improved over the past 25 years.

The American economy is the healthiest of any large economy ever, even if it may not compare favorably with your ideal. It's not perfect, but most of our problems aren't directly financial. We're overregulated in general.

Nonsense. The economy has been growing at an average of 2%-3% annually for several millenia.
I don't think so. If by "several" you mean "two," and if by "2%-3% annually" you mean "2% annually," then the economy should be around 100,000,000,000,000,000 times bigger than around 4 AD. You might get 3 orders of magnitude by increased population, and a couple to a few more orders of magnitude by better technology, etc., but 17 orders of magnitude is just not plausible. The bottom line is that there must have been long stretches over the last millenia over which [geometric] average growth had to be less than 2%.

LW: Michael, the economy can''t grow fast enough to overcome the waste that is produced. Much of the growth during the boom times is illusionary; later recessions wipe it out. Again, it is not the deficit that matters; it is how you pay for them.

"Nonsense. The economy has been growing at an average of 2%-3% annually for several millennia."

Can we confine ourselves to our present problems? Prior to 1910, Europe and America were on the Gold Standard. The US treasury could effect economic events only slightly through the sales of precious metals. Our present monetary problems have little to do with that period.

You seem also to confuse monetary growth with expansion of the economy. Monetary growth leads to waste which destroys wealth; it retards real growth.

"There have always been cycles of plenty followed by want, all throughout history. They can take different forms based on our economic and monetary systems, but the overall paradigm is inescapable."

You are reading history wrong, Michael. There is in history before 1910 the consequences of governmental acts; war, famine and pestilence were in plenty. But, there were no cycles-- business or otherwise. There is a clear cause- effect realtionship here. Banks would inflate their supply of money until the consumer lost confidence in the bank-- then there would be a Bank Run.

Easy Money does not bring prosperity-- only risk taking, good management and hard work can produce that. Monetary inflation is theft- whether private banks or governments do it. Theft does not produce abundance, but it can produce the illusion of it.

"The Fed smoothes out the bumps in the road, and has done quite a good job as financial theory has improved over the past 25 years."

The bumps in the road are evidence that we are doing something wrong, so a correction can take place. The Fed puts off the consequences of Easy Money temporarily, but it cures nothing. Easy money distorts our economy; it leads to errors. Only a depression where wages and prices fall will wash out the mistakes.

"The American economy is the healthiest of any large economy ever, even if it may not compare favorably with your ideal."

I am not talking about ideals, nor about perfection. I am talking about the consequences of Easy Money. The American economy is not healthy and will not be until Deficit Financing is ended. The other economies of the world are just sicker than we are.

"It's not perfect, but most of our problems aren't directly financial. We're over-regulated in general."

Yes, we are over-regulated. But, both monetary inflation and regulation are part of the same symptom: governmental arrogance. Governments have power, but do they show any competence in managing an economy? Not at all.

LW: I'm certainly not only talking about monetary wealth, and I don't see why we should limit the scale of time we're talking about. You said growth is illusory, but on just about any time scale it's obvious that's not true.

How does the existence of Bank Runs have anything to do with business cycles? They're all related phenomena. The economy is an upward-trending random-walk, which means that it sometimes wanders downward for periods of different lengths. That's inescapable.

I just don't see how you can call the greatest wealth-generating engine ever (the American economy) incompetent. Compared to what? Some theoretical ideal perhaps.

What percentage growth over time would you consider "healthy"? An absolute 2% per year with no variation? What about -10% to +20% per year with an average of +5%? Which is "healthier"? Something in between? That's what we've got now.

"LW: I'm certainly not only talking about monetary wealth, and I don't see why we should limit the scale of time we're talking about. You said growth is illusory, but on just about any time scale it's obvious that's not true."

American growth was not always illusionary; we did go during the 19th Century from being a third world country to the richest in the world. There were enormous productivity gains in the 20th Century which were consumed mostly by the government. My point is that it became difficult to determine what was real growth once we got a central bank, the Fed. The cost of government went from under 10% of GDP in the 1900 to over 40% now. Does this have no cost?

"How does the existence of Bank Runs have anything to do with business cycles? They're all related phenomena. The economy is an upward-trending random-walk, which means that it sometimes wanders downward for periods of different lengths. That's inescapable."

No. You are using a faulty model; economies don’t have to decline.

The economy is what creates real growth; money creation does nothing good. It is a form of fraud. Bank runs were a local phenomenon prior to the Fed. A single bank that got too greedy in making loans with checking account money soon found its depositors lined up outside its door-- a bank run. Corrupt bankers then colluded to bail each other out. This kept down the runs on single banks, but that caused regions of banks to fail together. When all the banks are controlled by a single cartel, the Fed, then they sink or swim together.

The Fed tries to control the creation of money, but its performance has been spotty. The Great Depression couldn't have begun or drug on until World War 2 without the Fed's actions. The Fed creates “the Business Cycle” by trying to keep money creation within a narrow range to avoid catastrophe. Sometimes, it increases the money supply to avoid a depression; it then pulls back when the economy gets too hot.

But, events are often beyond the Fed's control. If Al Qaeda had been able to complete some of its other plans, the attacks on Chicago and LA, America might have found itself in a depression. It was a close enough call as it was. Deficit Financing creates an unstable condition; it depends on fooling the citizenry as to the value of money. When the citizenry decides to wake up; it will take evasive action, and the whole house of cards will fall down.

"I just don't see how you can call the greatest wealth-generating engine ever (the American economy) incompetent. Compared to what? Some theoretical ideal perhaps."

Compared to a relatively free economy: the US in the 19th Century.

"What percentage growth over time would you consider "healthy "? An absolute 2% per year with no variation? What about -10% to +20% per year with an average of +5%? Which is "healthier"? Something in between? That's what we've got now."

Health is not related to percentages. Health has to do with the absence of government induced market distortions. How real are those figures you cite, anyway? How could we go from 10% to 40% of the GDP being consumed by government without those figures showing a shrinking of the economy? Answer? The economists cooked the books for the government. They said that "government services" added, not subtracted from GDP. They forgot about the taxes which shrank the economy which had to pay for those services. Even if these services were what the citizenry wanted, wouldn’t the “government services” and taxes cancel each other out? But, most of us didn’t want those services; not at what they actually cost us. The more the government did for us the bigger the GDP grew. Meanwhile, our standards of living fell or stagnated. Don’t blame that on the economy.

The point of the original thread was that right now deficits are not a real problem. They will be later on in the “Business Cycle” when we have to pay for them in higher taxes or price inflation. The Dems are playing a cynical game; they don’t really want to end deficits; they just want to spend the money derived from them on their issues. And part of this is pure hypocrisy; the recent Bush administration social spending was a bribe to the Dems to keep them from scuttling the "War on Terror."

LW: The GDP is over $10 trillion, and the federal budget is a bit over $2 trillion -- that's 20% in my book, not 40%. Throwing in the states and cities doesn't get you much higher

Standards of living are continually increasing. Provide sources that say otherwise, along with how they measure it.

I think our government is too big and too intrusive, but apparently not to the extent you do. It concerns me, but I've got bigger fears at the moment. Wars and such have larger effects on the economy than the Fed does.

My point is that if deficits are kept below the debt growth rate they won't be paid for later by taxes or price inflation, but by decreased surpluses (which would be refunded anyway!).

LW: The GDP is over $10 trillion, and the federal budget is a bit over $2 trillion -- that's 20% in my book, not 40%. Throwing in the states and cities doesn't get you much higher

City, State and Federal, individual and corporate taxes, Social Security, unemployment insurance, direct fees, monetary inflation and excise taxes is well over 40 percent of GDP. The 10% figure for 1900 I cited was for all government as well. Don't forget the off budget items. And the money the government spends and doesn't account for. Perhaps, I was too loose in my definition of government. Say-- 25% for federal-- a huge amount though. I noticed that you didn't address my comment that the figures you touted may not be accurate.

"Standards of living are continually increasing. Provide sources that say otherwise, along with how they measure it."

Standards of living do not continually rise; During the Carter years we were hit hard by high unemployment, a stagnant economy and rising prices. Greenspan has been very cautious; the economy has been fairly stable during Reagan's and later president's terms. But, no attampt has been made to cured a thing. And unforseen events can overturn the whole applecart. Terrorism is just one.

Regarding references, I already gave you one. If you won't look at it why bother giving you others? Do you think the historians don't know what is going on? They know all about John Law.

"I think our government is too big and too intrusive, but apparently not to the extent you do. It concerns me, but I've got bigger fears at the moment. Wars and such have larger effects on the economy than the Fed does."

I agree. That is why I'm not bothered by the deficits now. We have a war to win. I just wanted to give you a framework to judge the deficits against. Our larger problems will wait. The Easy Money Game will end in its own time. Frankly, I expected the game to be up sooner-- decades ago.

"My point is that if deficits are kept below the debt growth rate they won't be paid for later by taxes or price inflation, but by decreased surpluses (which would be refunded anyway!)."

Michael, you are playing mind games. We pay for Deficit Financing whether we recognize it or not. It may be more comforting not to recognize it, but how can you take evasive action if you don't know? Twenty-five years ago one person in ten thousand knew the effects of easy money. Now, it is less than one in five. Those that know are betting that the game will proceed further. So am I. But, I'm hedging my bets in case it all falls apart. It got very close to doing that on 9/11. If we had been in a declining, rather than a rising economy, it might have happened.