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The Deficit: Nine Myths We Can't Afford

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Has the federal government run out of money? Will we have to slash Social Security? Will we have to borrow dollars from China for our children to pay back?

The national debate over fiscal responsibility and sustainability is entering a new, critical phase. Today, an 18-member bipartisan commission to examine the government's fiscal problem will meet for the first time. Everything is on the table, including Social Security and Medicare.

With so much at stake, the time has come to examine our fundamental assumptions about government deficits and debt. The danger of accepting oft-repeated orthodoxies has been clearly demonstrated in the recent financial crisis. For decades, free market fundamentalism went virtually unquestioned, and we've all seen the result -- an epic economic catastrophe. We can't afford to make the same mistake on fiscal responsibility. It's time to consider alternatives perspectives before we rush down potentially destructive policy paths that could compromise our future.

The Roosevelt Institute's New Deal 2.0 blog asked seven economic thinkers to address what they see as the most dangerous myths currently circulating on the deficit. Several of these experts will be on hand to educate the public on April 28, 2010 at George Washington University in Washington, D.C. at a "Fiscal Sustainability Teach-In."

Myth #1: The government should balance its books like a private household.
Reality: Our federal government is the issuer of the currency, which makes its budget fundamentally different than the average citizen's.

Discussion of government budget deficits often begins with an analogy to a household's budget. People say: "No household can continually spend more than its income, and neither can the federal government". But there are big differences between a household and the federal government. You don't have the ability to print money in your living room, do you? Well, the government does. So how it finances its own debt and spending is different from the way you do.

A government is the issuer of the currency. The household, on the other hand, is the user. Households are restricted by the need to somehow get money into their bank accounts, or their checks will bounce. The federal government, by contrast, doesn't "have" or "not have" dollars. There is no vault or lock box where it "keeps" its money. In fact, it makes all of its payments simply by electronically crediting private bank accounts and there is no practical limit to which it can change those numbers up. Spending by the federal government always creates new money in the system, while taxation destroys it. When households and firms pay taxes, the money does not go anywhere; the government simply debits those private bank accounts by electronically reducing the amount of reserves they hold, i.e., by changing the numbers in those bank accounts down.

Government is constrained only by the inflation it can create by over-spending, but its ability to spend is numerically unlimited. Households are constrained by their ability to get dollars from some form income and from borrowing, and both of those have real limits.

~Pavlina R. Tcherneva, Assistant Professor, Franklin and Marshall College

Myth #2: Fixing Social Security and Medicare will require "tough choices."
Reality: Social Security and Medicare are not facing a financial crisis.

A new poll by the Pew Research Center suggests that nearly 80% of Americans don't trust the federal government. Unfortunately, we appear all-too-willing to trust the government when it tells us that Social Security and Medicare are heading for bankruptcy. Indeed, the same poll shows that fewer than half of us now hold a favorable opinion of the Social Security Administration (down 13% from a decade ago). No wonder. The drumbeat over the so-called "crisis" facing Social Security and Medicare has reached a fever pitch.

The government's message is clear: Both programs face significant trouble ahead, due primarily to the aging of our population. In order to deal with the looming problems, we will have to make "tough choices." Not everyone can have the money they were promised.

If you've been around a while, you've heard this all before. Remember the Greenspan Commission? This is the group that President Reagan appointed to "fix" Social Security in the early 1980s, the last time the system was on the brink of "collapse." Thanks to the "reforms" that were enacted in 1983, Americans are working longer (they raised the retirement age) and paying more (they accelerated increases in the payroll tax rate). And now we're being told it was all for nothing -- the system is broken again?

The truth is, the system was never broken in the first place, because the government's ability to pay benefits does not in any way depend on the balance in the Social Security or Medicare Trust Funds. Benefit checks come directly from the Treasury, and, as Alan Greenspan has admitted, "[A] government cannot become insolvent with respect to obligations in its own currency."

And so the question is not whether the government needs to make "tough choices" in order to keep these vital programs afloat. The question is, will politicians make the toughest choice of all and tell the American people the truth: Social Security and Medicare face no financial crisis now or in the future.

~Stephanie Kelton, Associate Professor, University of Missouri-Kansas City, Missouri

Myth #3: We are passing on debt to our grandchildren.
Reality: Payments on Treasury securities are a matter of data entry, not a financial burden.

Most people don't realize that government debt -- Treasury securities -- are nothing more than savings accounts at the Federal Reserve Bank in Washington.

There are about 13 trillion dollars in Treasury securities at the Fed. Collectively, these savings accounts are known as the national debt. The national debt represents a portion of the combined savings of US residents, corporations, banks, and foreign governments. And most folks probably don't know that when a person buys them, the Fed simply transfers the dollars from her checking account to a savings account at the Fed called a "Treasury security."

Tens of billions of dollars of these Treasury securities come due every week. When that happens, the Fed pays off that "debt" simply by transferring the dollars, plus interest, out of these savings accounts and back to the holders' checking accounts.

In the future, when our grandkids make payments on Treasury securities, they will simply credit accounts at the Fed-just as we do today, and as our grandparents did before us. It is a simple matter of data entry, and not a financial burden.

If the government spends and taxes wisely today, our grandchildren inherit roads, dams, parks, public buildings, and, most importantly, an educated and healthier workforce. These things are admittedly hard to value precisely-but there can be no doubt that our grandkids will be much better off having been born into a society that has modern infrastructure and services that our government policies can help to provide.

~Randall Wray, Professor of Economics, University of Missouri-Kansas City, Missouri

Myth #4: What we don't tax we have to borrow from the likes of China for our children to pay back.
Reality: Paying our debt holders back consists of transferring funds between accounts.

One constantly hears that the Chinese (and other external creditors) "fund" our deficit. The folklore is that when China finally sells off its US bond holdings, those yields will sky-rocket. The dollar will then crash, no one else will want the debt, and it will be the end of America as we know it.

To debunk this myth, you need to know two things. First, all foreign governments have checking accounts at the Federal Reserve Bank called "reserve accounts." Second, US Treasury securities are nothing more than savings accounts at the same Federal Reserve Bank.

How does China get its dollars? It sells things to us. And when China gets paid, those dollars go into China's checking account at the Federal Reserve Bank.

And when China buys US Treasury securities, what happens? The Fed transfers China's dollars in its checking account at the Fed to its savings account at the Fed. We call that "borrowing from China" and "going into debt to China." But it's not really "borrowing" in the sense of creating an external constraint whereby we have to defer spending to "pay back" China. The Fed simply pays off China's "debt" by transferring the dollars, plus interest, back to the holder's checking account, which it can create at the stroke of a keyboard as the monopoly issuer of dollars.

The dollars are nothing more than data entry on the Fed's computer. They have no other existence. And it has no impact on the government's ability to spend as to whether China's dollars are in their checking account or savings account.

All we owe China is a bank statement that shows them where their dollars are. Sadly, they know this. But they also know that we think we are dependent on them, and take advantage of our error.

~Marshall Auerback, Senior Fellow at the Roosevelt Institute and Warren Mosler, President, Valance Co.

Myth #5: The government must tax or borrow to get money to spend.
Reality: Government spending is not constrained by revenue.

As explained above, the Federal government neither "has" nor "doesn't have" dollars. The government spends by creating new money and taxes by destroying money, which simply involves changing numbers in bank accounts. Suppose the government pays Social Security benefits to a retired teacher, Mrs. Jones, in the amount of $1,500 a month. At the end of the month, the checking account of Mrs. Jones is credited by $1,500. Did the government need your tax revenue to pay Mrs. Jones? No! It simply changed the numbers up in Mrs. Jones's bank account, basically creating new money. On April 15 Mrs. Jones sends a check to the IRS to pay her taxes. When the government gets the check, what does it do? It simply changes numbers down in Mrs. Jones's bank account, destroying the money.

What about selling government bonds, which is mistakenly called borrowing? These are simply interest-earning assets, similar to a savings account. Suppose Mrs. Jones has $1,000 dollars in her checking account on which she would rather earn interest. So she buys a Treasury security. What happens? Basically a bond sale involves moving funds from checking accounts to savings accounts (Treasuries) at the Federal Reserve Bank.

So if the government doesn't need to tax to be able to spend, why does it tax at all? There are two reasons. First, the government creates demand for its currency through taxation. If the public didn't need the dollars to pay its taxes, it wouldn't be willing to sell goods and services to the government in return for pieces of paper (or numbers in a checking account). Taxes, then, are what give value to money. Second, the government uses taxes to control the public's spending power. When the public has too much spending power, government taxes some of it away to avoid inflation. When there is too little spending so that unemployment results, it lowers taxes to boost private spending.

Any and all financial constraints on government spending such as issuing government bonds dollar for dollar against deficit spending, debt ceilings, and restrictions on the Fed's ability to buy treasury securities are purely political and necessarily self imposed, because they are imposed on us by our chosen institutional arrangements and not by something inherent in our economic system.

~Yeva Nersisyan, Doctoral candidate in economics, University of Missouri-Kansas City, Missouri

Myth #6: Deficits and government borrowing takes away savings.
Reality: Deficits add to income and savings.

The truth is that deficits add to the total monetary savings held outside of government. To the penny. That's right, if the government deficit was 1 trillion dollars last year, then total net savings of everyone outside of government went up by 1 trillion. Not a penny more or a penny less.

Let's look at a simple transaction where the government deficit spends $100. Say the government sells US $100 of new treasury securities. We buy them and our bank account goes down by $100 when we pay for them, but we have the $100 of treasury securities we bought. Are we any poorer? Of course not! In fact, since we bought the securities voluntarily, we probably did it because we think that purchase made us richer. All we did was exchange $100 that was in our checking account for a $100 Treasury security.

After we pay the $100 for the Treasury securities, the next thing that happens is the government then spends $100 by buying something from us. So we now have both the $100 the government just spent and the $100 of Treasury securities we just bought.

So because of the $100 of deficit spending, we got our $100 back in our checking account, and we also have $100 in Treasury securities. Our monetary wealth is now $100 more than it was before.

The deficit spending of $100 added $100 to our savings. Yet all of our leaders insist that deficits take away from our savings.

You can now understand the reason our savings went up so much last year. It was because the government deficit was so much higher. Now you know more about that than anyone on TV.

~Warren Mosler, President, Valance Co.

Myth #7: We'll end up just like Weimar Germany or Zimbabwe.
Reality: Hyperinflation in both countries was caused by circumstances far different than ours.

The minute you challenge the assumption that the government should not spend when it has a large deficit, out comes the charge that we'll get some horrible hyperinflationary outcome like Weimar Germany or Zimbabwe.

Yes, once the economy gets to full employment, then extra government deficit spending can start driving up prices. But what happened in Weimar Germany was very different. During that time, the government was forced to pay extremely large war reparations in foreign currencies which it didn't have. So it had to aggressively sell its own currency and buy the foreign currency in the financial markets. This relentless selling continuously drove down the value of its currency, causing prices of goods and services to go ever higher in what became one of the most famous inflations of all time. By 1919, the German budget deficit was equal to half of GDP, and by 1921, war reparation payments represented one third of government spending. And guess what? On the very day that government stopped paying the war reparations and selling its own currency to buy foreign currency, the hyperinflation stopped.

In Zimbabwe, the situation is also very different from ours. There, the conditions for hyperinflation were caused by the destruction of nearly half of the country's domestic food production via misguided land reforms, plus a civil war which eliminated much of the economy's productive manufacturing capacity. In response to food shortages, the Bank of Zimbabwe used valuable foreign exchange reserves to buy imported food, leading to a lack of foreign currency to purchase essential raw materials. Manufacturing output collapsed, but the government used much of the remaining foreign exchange to dole out political favors, rather than adding to the country's productive capacity. The end result was inflation and then hyperinflation.

In the US, hyperinflation will not be an issue if the government spends while it has a large deficit because with high unemployment and unused yet functioning factories all across the country, there is plenty of room to cut taxes and/or increase spending to get us to full employment. This is true no matter what the size of the federal deficit. Ultimately, inflation (and then hyperinflation) is about competing distributive claims over real resources, such as oil, gas, water, etc. A "sustainable" fiscal policy, especially with respect to hyperinflationary risks, then, is really about both the establishment of full employment and the implementation of well-crafted policies which deal with the constraints created by, for example, depleting natural resources.

~Marshall Auerback, Senior Fellow at the Roosevelt Institute and Rob Parenteau, sole proprietor of MacroStrategy Edge

Myth #8: Government spending increases interest rates and 'crowds out' valuable private sector investment.
Reality: Banks can lend essentially without limit, and the Fed can hit any interest rate target it chooses.

Ask an economist what determines the interest rate, and she'll probably mutter something about supply and demand or "market forces." Ask the same economist what determines the level of saving and investment, and the answer probably won't change very much. This is because most economists were trained using textbooks that have not been rewritten since the United States went off the gold standard after WWII.

Back then, we had a monetary system that really did limit the growth of the money supply, and too much government spending really could force rates higher and crowd out other forms of spending. It is all based on something economists know as Loanable Funds Theory, which describes a market in which there is some limited pool of savings available to satisfy the demand for credit. Thus, deficit spending required the government to compete (with private borrowers) for a portion of these limited resources. Because the capacity to lend was constrained under the gold standard, the added competition could drive borrowing costs (i.e. the interest rate) higher.

Decades later, the monetary system looks completely different. But economists continue to treat governments as if they are the users of the currency (as opposed to the issuers) and to treat banks as passive money lenders -- there simply to broker deals between savers and borrowers. In truth, banks can lend essentially without limit, regardless of what the federal government is doing, and the Federal Reserve can hit any interest rate target it chooses.

~Stephanie Kelton, Associate Professor, University of Missouri-Kansas City, Missouri

Myth #9: The money spent paying interest on the national debt could be spent elsewhere.
Reality: Interest rates can easily be brought to zero and are not an obstacle to federal spending.

Government spending is not operationally constrained by revenues (as outlined above). So interest payments are not an obstacle to any other payments. Further, the Fed (a branch of government) sets the overnight rate-thus, it is a policy variable and can be set wherever policy wants to set it. Right now short term rates are set near 0%, and the Fed could leave them there permanently, which would bring down interest on Treasury securities to near 0%. Finally, Treasury can elect to issue only 3 month bills, which would bring government interest payments towards 0 over time.

Conclusion: Interest on the debt is not currently an obstacle to increased federal spending and/or tax cuts. And it's a very simple matter to bring interest payments down to 0 in any case.

~Randall Wray, Professor of Economics, University of Missouri-Kansas City, Missouri

Cross-posted from New Deal 2.0.