Sunday, October 21, 2012

Deficit drivel.

The conventional and economically illiterate story about the deficit (repeated a thousand times by politicians and other ignoramuses) is as follows (in green).

There’s a deficit. We could reduce it by raising taxes or cutting public spending. But that hits growth: the last thing we want in a recession.

On the other hand if the deficit continues, that can lead to too large a national debt, which in turn means creditors may ask for higher rates of interest. Now we’re really in a bind, aren’t we?

Answer: “no, we’re not.”

The above nonsense was unfortunately repeated recently by “Economics Help”, an economics tutorial site (which publishes informative material 99% of the time).

The truth about deficits and debts.

The following explanation is actually just an expanded version of one of the most succinct phrases ever uttered by an economist: it was Keynes’s phrase, “Look after unemployment, and the budget will look after itself”. But the meaning of that phrase is way beyond the comprehension of the above ignoramuses, which is why it is necessary to explain the phrase (over and over and over again).

First, deficits do not need to accumulate as extra debt. As Keynes, Milton Friedman and a hundred other economists have pointed out ad nausiam, deficits can equally well accumulate as extra monetary base. Unfortunately the above Economics Help article gets this point wrong: its opening paragraph reads, “A budget deficit occurs when a government spending is much greater than tax revenues. This leads to an accumulation of public sector debt.”

Indeed, thanks to QE, recent deficits ACTUALLY HAVE accumulated to a large extent as extra base rather than debt. Doh!


Indeed, that’s exactly what has happened over the last two or three years (Doh again).

Moreover, the very fact that debt holders are happy to expand their debt or monetary base holdings is proof that the private sector’s desire to save money rather than spend is contributing to unemployment: it’s proof that Keynsian paradox of thrift is at play. I.e. as long as interest rates remain low, running a deficit with a consequent rise in the debt or base is EXACTLY THE RIGHT POLICY.

Rising interest rates.

In contrast, if the rate of interest demanded by creditors DOES RISE, that is proof that creditors are NOT SO WILLING to hold or expand their holdings of debt or base (forgive the statement of the obvious, but this article is very much into stating the blindly obvious).

Given rising interest rates, a country will not, REPEAT NOT, have to pay any additional interest immediately: it will only pay additional interest (if it’s silly enough to actually do so) on NEW DEBT or “rolled over” debt.

But the rational reaction in that scenario is to just abstain from issuing new debt. I.e. the rational policy is to pay back creditors EITHER BY by getting the money from raised taxes (and/or public spending cuts), OR BY printing money and paying off the creditors.

As to which of the latter two to go for, that depends on whether the economy can take more stimulus or not. If it can, then the money printing option is best. If not, the raised taxes / public spending cut option is best.

And the reaction of the ignoramouses to the above two options is a predictable as it is boring. They react to the money printing option with the word “inflation”. Well there won’t be any inflation if the economy still has significant unused capacity (exactly what has happened over the last two or three years  - doh again).

And as the idea that those tax increases or spending cuts will hit growth, they’ll have absolutely no effect on growth in the sense that if inflation is allowed to run riot, far from bringing increased growth, it just brings chaos and REDUCED GROWTH.

In other words (irony of ironies), given rising inflation, confiscating household’s money via tax (or implementing public spending cuts) actually make everyone better off, or at least it prevents them becoming WORSE OFF as a result of the damaging effects of excess inflation.

To summarise, for a country that issues its own currency, the best policies are:

1. Given a large deficit and rising national debt and excess unemployment the correct response is to continue with the deficit and rising national debt (though letting the deficit accumulate as extra base would do equally well).

2. Given excess unemployment and rising interest rates the correct response is to continue with deficit but let it accumulate as extra base.

3. If the latter looks like exacerbating inflation, then unemployment is not excessive – at least in the sense that there is some level of unemployment  below which it is difficult to go without inflation kicking in. And if inflation IS RISING, that point has probably been reached. Dealing with the remaining unemployment is then difficult: at least, the problem cannot be solved by the simple expedient of increasing aggregate demand.


Sites that broadcast a similar message to the above:

Or if you like videos (h/t to Mike Norman): 

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