The President remains trapped in the talons of the deficit hawks

hawk-150Marshall Auerback here with a post which I originally published at New Deal 2.0.

Last Friday, Mr. Obama and the GOP staged the equivalent of a British Parliamentary Question Period in front of the TV cameras. It showed the quick-thinking, articulate President at his best. Unfortunately, the subsequent Saturday morning national radio address showed him at his worst. Obama reiterated the need for job creation, even as he decried government deficits, which allegedly imperil our long term economic prosperity. It’s like calling for an open house policy, whilst simultaneously putting explosives on the door knobs.

“As we work to create jobs, it is critical that we rein in the budget deficits we’ve been accumulating for far too long – deficits that won’t just burden our children and grandchildren, but could damage our markets, drive up our interest rates, and jeopardize our recovery right now”.

Give Obama credit. He packs a veritable trifecta of innocent, but deadly frauds into one sentence — government debt is bad, markets determine interest rates, and  deficits represent a form of “intergenerational theft.” Then, he adds several new ones to boot.

Unfortunately, he’s got it backwards. The deficits he decries actually help to sustain demand and create jobs, thereby supporting the economy — not destroying it. And he reflects a commonly held belief that growing government debt represents a burden on our children and grandchildren, implicitly suggesting that future generations will have to reduce consumption in order to pay the taxes required to pay off the outstanding debt. Related to this is the fallacy that too much bond issuance will create a “debtors’ revolt”, whereby “the markets” will force the country to pay higher interest rates in order to “fund” its spending.

A Few Overlooked Facts on Deficits

Where to begin? Since the days of George Washington’s administration, national budget deficits and increased public debt have been the rule on all but about six very short occasions. And the US has generally prospered. Why? Far from being a burden, the deficits, and the corresponding government bonds, constitute the foundation of private financial wealth in any nation that creates its own sovereign currency for use by its citizens. Debt owed by the government yields net income to the private sector, unlike all purely private debts, which merely transfer income from one part of the private sector to another. In basic national accounting terms, government deficits equal non-government savings surpluses.

Private holdings of government bonds also constitute an income source — that is, the government interest payments on its outstanding debt constitute another avenue for stimulus. So when the government retires debt, it reduces private incomes — just as when it runs budget surpluses, it constrains private sector demand directly by reducing private income and access to adequate currency. Just ask any pensioner if he/she is happy when the income stream from annuities has declined.

Take away that debt, and you take away income. It is no coincidence that the budget surpluses of the Clinton years (wrongly trumpeted as a great fiscal triumph by President Obama) subsequently led to recessions: government budget surpluses ultimately restrict private sector demand and income growth and force greater reliance on private debt. Does anybody think it is a coincidence that two of the longest and largest periods of budget surpluses in America history — the periods of 1997-2000 and 1927-1930 — were followed by calamitous economic collapses?

There are ample analyses which explain how government surpluses drain aggregate demand (here, here, and here). Suffice to say, a government budget surplus has two negative effects for the private sector: the stock of financial assets (money or bonds) held by the private sector, which represents its wealth, falls; and private disposable income also falls as tax demands exceed income. And, as Stephanie Kelton has noted, the case of Japan illustrates that despite a debt-to-GDP ratio in excess of 100%, the Bank of Japan never lost the ability to set the key overnight interest rate, which has remained below 1% for about a decade. And, the debt didn’t drive long-term rates higher either.

Furthermore, now that we’re off the gold standard, Chinese and other Treasury buyers do not “fund” anything for us, contrary to the completely false and misguided scare stories that deficit hawks and, and now Obama, implicitly endorse. (Click here for an explanation). Legions of economists, investment advisors, Wall Street practitioners and policy makers continue to peddle such gold-standard thinking to their citizens nationwide. To paraphrase Churchill, “It is as though a vast Gold Standard curtain has descended across the entire body of public thinking.”

Obama’s Deficit Confusion

Let’s consider a real world example to demonstrate the President’s conceptual confusion on government deficits. We’re in a recession. Our American citizen who was working in a pie shop has lost his job even though his productivity was just as high during the boom years. As the recession intensified, pie demand fell, as did consumer demand in general. Fearing that their wealth holdings are not going to appreciate as quickly as they did in prior periods, households are saving more money out of their income flows.

The pie guy wants to exercise his freedom to work hard for money. So do 152 million other people. But there are jobs available for only 138 million of them, given current business perceptions of money profit prospects from production now and in the future. The pie guy is stuck with over 15 million other people who would like to exercise their freedom to work hard for money. Over 6 million of those people have been trying to exercise that freedom for over half a year, with no luck. They are dumpster diving for leftover pie scraps.

In desperation, the pie guy has gone back to the pie shop to offer his services for a lower money wage, but unit pie demand is still down, even though the owner has cut pie prices. However, the pie owner, facing lower prices per pie, decides to hire the pie guy back at a lower wage and fires one of his other workers to scratch his way to a little higher profit. Are we all any better off? I suppose pies are cheaper, but then so to are incomes earned by pie makers lower.

In that situation, someone else has to take up the spending slack. Fortunately, we live in an economic system in which a government can freely spend and fill the gap left by the private sector. It has the unique capacity to spend without the constraint of a private firm on productive job creation, thereby increasing output, not just redistributing it. Just giving the pie firm a payroll tax cut on new hires is not going to generate more jobs. Rather, giving it to all employees will lead to more pie sales. Instead of decrying the government deficits, then, the President should be celebrating them as a form of economic salvation.

The problem obviously isn’t about money which a government can always create. The ultimate irony is that in order to somehow ‘save’ public funds for the future, as the President appears to be advocating, what we do is cut back on expenditures today, which does nothing but set our economy back and cause the growth of output and employment to decline. Worse yet, the great irony is that the first thing governments generally cut back on is education — the one thing the mainstream agrees should be done that actually helps our children 50 years down the road. Education cutbacks — as any Californian can tell you — are something that does hurt us, as well as harming our children AND our grandchildren down the road. This is the true “intergenerational theft”, not “runway” government spending.

The False Household Budget Analogy

Like many other people who embrace the nostrums of the Concord Coalition (an advocacy group supporting the deficit hawk themes), the President continues to view government spending through a false household budget analogy:

“There are certain core principles our families and businesses follow when they sit down to do their own budgets. They accept that they can’t get everything they want and focus on what they really need. They make tough decisions and sacrifice for their kids. They don’t spend what they don’t have, and they make do with what they’ve got.”

Yes, it’s true: If households spend more than their income now, they have to borrow. To pay the loan back they have to ensure that they can dedicate adequate income in the future, either by increasing incomes somehow or diverting existing income from consumption. If a household borrows too much, it will face major corrections in its balance of income and expenditure and consequently may have to seriously forgo spending later.

That is the logic that the users of the currency have to consider every day. They have to finance every $ they spend and so planning is required to ensure they don’t blow out their personal balance sheets. If all households attempt to net save by spending less than they are earning, and businesses attempt to net save (reinvesting less than their retained earnings), then private sector incomes and real output will decline absent an increase in government spending.

But it’s not the same for a government. The government is the creator of a currency. It can spend now. It can also spend later. And it can service and pay back the debt without compromising anything. A government, unlike a household or a private business, can choose to exact greater tax revenues by imposing new taxes or raising tax rates.

Notwithstanding the obvious reality that sovereign governments have no solvency risk because they create their own currency, most financial commentators (and the President’s own advisors) still waste their time talking about sovereign default risks. Unfortunately, the President implicitly legitimizes this sort of talk when he speaks about the need for government to embrace budgeting like a household does. This is what we presume he has in mind when he discusses the long term dangers of government deficits. Firms, households, and even state and local governments require income or borrowings in order to spend. But the federal government’s spending is not constrained by revenues or borrowing. It is constrained only by what our population chooses as national goals.

Getting Past the Deficit Myth

We would all rather live in a world where profit prospects are so abundant that business investment spending is high enough to insure full employment given household preferences to save out of income flows. But historical and current experience suggests that is a rare configuration indeed. Ideally, that would be the business sector investing more than it retains in earnings. But in recent decades, this happens only during asset bubbles, and we know how that story ends. Alternatively, the foreign sector could deficit spend — the US could run a trade surplus. But the reality is that US firms have chosen to reinvest in low cost production centers abroad (or would prefer to use free cash flow to engage in short run shareholder value maximization through various financial engineering efforts, including M&A) so the US-based production structure no longer matches foreign demand very well. Ironically that leaves government fiscal deficit spending as the sole remaining mechanism to insure the freedom of its citizens to work hard for money.

The President, unfortunately, has yet to put the pieces of the puzzle together. He also fails to understand the idea that a government like the United States — i.e. one that issues a sovereign currency — can meet any and all outstanding financial obligations, provided the debts are denominated in the national currency. In this regard, the size of the national debt is irrelevant. This myth, and this myth alone, underpins arguments by orthodox economists against government activism in macroeconomic policy. The President does his Administration and the country no service by continuing to jump on this mythical bandwagon.

Myths may constitute good grounds for literature, but they are a horrible foundation for sound economic policy.

Marshall Auerback is a market analyst and commentator.

Marshall Auerback


Marshall Auerback, has 29 years experience in the investment management business, serving as a global portfolio strategist for Madison Street Partners, LLC, a Denver based hedge fund. He also has also worked as an economic consultant to PIMCO, the world’s largest bond fund management group. He is a Fellow at the Economists for Peace and Security, a Research Associate at the Levy Institute, and a non-executive director of Pinetree Capital in Toronto, Ontario, Canada.