Friday, December 13, 2013

The Cause of Deficits and Other Myths

I suggest we stop thinking and speaking of deficits as a “thing” or an object.

Budget deficits are endogenous to the non-government.

A deficit is a residual…something left over after all other entities are accounted for.

A deficit is not a budget item, it is an outcome, like GDP is an outcome. Neither are “things” per se…they are measurements of the outcome of economic events, although deficits manifest themselves in a real-world account we call savings. A deficit is a change in an account balance of the account we call savings (aggregate savings).

Savings (for the U.S.) is the total of all dollars and bonds in existence.

Net savings is the total of all dollars and bonds in existence once outstanding dollar liabilities are subtracted.

In this context a deficit is like a fuel gauge…which tells us how much is in the tank after we fill it up…a deficit tells us how much the non-government was able to save, after taxes were collected…what we have acquired over the current year, which is added to our prior year's account balance.

Deficit is a misnomer…it is a creature of economic activity in the non-government expressed in a term that applies to the government…the opposite side of the transaction.

In other words the object system is switched in mid-sentence. We take a private-sector surplus and refer to it as government deficit…which is nothing more than simple accounting description of the two sides of a transaction… but in doing so we (purposefully?) conflate cause and effect.

What a clever way to dupe the masses into supporting policies that will most likely hurt them.

For the non-government it is properly called a surplus. For the government a deficit. The net result is the ability of citizens to hold financial wealth as compensation for it’s surplus of effort.

The “cause” is a direct function of decisions made in the non-government. If agents in the non-government are successful in their attempts to save or earn a profit, the outcome will result in a government deficit…beyond control of the government, other than it's failure to spend enough to enable the sought-after outcomes to occur.

If citizens attempt to save or profit while the government fails to support those desires…by not spending enough…the economy will contract or collapse. This has to be so because (1) agents will not spend their savings unless they are practically forced to and (2) companies will experience below-expected sales if their customers experience lower incomes, resulting in lower profits or losses…leading to higher unemployment as inventory piles up.

It is (mostly)•• beyond governments control because it is an ex-post event…we cannot go back in time and change what has already happened…spending and income have already happened…tax rates cannot be changed on-the-fly…the outcome is determined already, whatever residual remains after taxes are collected are history.

Any governmental attempt to “control” the size of the deficit (normally meant to reduce it) will result is some kind of economic malfunction…either a banking crisis, a drop in demand that leads to lost sales, increased inventory and higher unemployment, etc.**

The Clinton surpluses led almost immediately to a recession, to which the new President responded by spending more (and taxing less) which still wasn't enough and we have what we have now…the longest and most destructive recession in the Nations history. The six previous times budget surpluses were tried they ended in depressions. Don't worry, this thing isn't done yet.

If the government lowered spending thinking the current year deficit will get smaller, it would have to rely on private borrowing to take up the slack in order to maintain aggregate demand…Businesses will not invest more if there is less money on the table to win, and human nature will not move people to spend their savings if the economic outlook is grim.

The money businesses invest in anticipation of profits is not enough to buy their products. At best, businesses (in aggregate) could hope to break even, but some people wills save. This claim is made without reservation.

Further, people are reluctant to spend prior savings, to the point where they would almost have to be forced to do so, so the best outcome possible for businesses in absence of government spending is that consumers will go out and borrow to spend so that they can have what they want/need and businesses can earn a profit…a gain.

But the funds to make payments can’t come directly from more borrowing by the same borrower… lest anyone thinks a typical consumer can obtain a mortgage loan (or any loan) and then go back to the bank and borrow again to fund the payments on a continuous basis.

Consumers cannot depend on others to borrow money to help them…it may be possible, but the odds are against the borrower, and there are settlement and distribution frictions at play, beyond the friction of saving.

Further, the proceeds of loans create income in the economy and are subject to taxes and saving just as any income would be.

So a significant portion of the money needed to make payments is removed from the system, disappeared, and some subset of loans will have to go into default if the funds necessary to make payments that (don’t exist anymore) don't materialize from somewhere.

If anyone thinks that under this scenario agents can continue to borrow to make up for the funds that were annihilated, try modeling the flows with a spreadsheet and see how far the dynamic lasts before debt service overwhelms income. The system will overwhelm itself quickly.

Try to imagine any self-sustaining process in the known universe…you won't be able to find one.

This is consistent with the 2nd Law of Thermodynamics, which rules out perpetual motion… a system will ALWAYS be subject to losses to friction, leading to the conclusion (and law) that no system can be self-sustaining, not even one that is a mathematical abstraction.

An effect can never be greater than it's cause.

Such a financial system would last year or two or three at most. That is an optimistic picture. The Eurozone is proving it once again for us, and it isn't even subject to amortization…the bonds are interest-only.

It’s never been tried in the U.S. We as a Nation have always taxed less than we have spent…we have never really attempted or tested the impossibility of perpetual motion with our financial system.

In the U.S. we have always enabled our citizens desire to save.

It is the epitome of cognitive dissonance to claim that our economic success* is a result of credit expansion or business investment while ignoring all of the net money allowed to remain in the non-government as a result of the government taxing less than it spends, or all of the government investment we call public spending.

It is a responsibility of government to enable those savings desires, because if it doesn’t the economy will not function in a way that is beneficial to the majority of it’s citizens.

••••••••••••

Money does not "circulate" to any significant extent.

* Success in this context is defined as full or near-full employment.

•• Government CAN effectively reduce the size of deficits by taxing high incomes (rentier income, capital gains, inheritance) at a higher rate. This would be equivalent to taxing prior savings as long as their incomes remained high…we would be effectively going back in time to remove excess wealth. This would will reduce OVERALL savings, but leave a reasonable distribution of savings intact, ie wouldn't affect middle-income households.

We did just this in the period between 1936 and 1963, when the top marginal tax rate averaged near 90%. During the post WWII period the U.S. experienced unprecedented growth and moderate deficits. Go figure.

Doing so does not give the government any more money to spend…the government doesn’t need money because it can produce money at will if it so chooses. The Fed/Treasury can’t stop it either :-)

Doing so will not decrease economic activity…the prior balance (gross savings) has virtually no propensity to be spent. In order to spend one’s savings, one first would have to spend all of one’s income.

For the wealthy this is highly unlikely…so unlikely as to be safely ignored…

Being wealthy generally means one has been consistently able to spend less than earnings.

As long as the balance is rising, savings are not being spent in any significant amount. If someone tries to claim savings sloshes back-and-forth like alternating current, fine…but then they would have to explain why it doesn't appear in GDP numbers.

There exists some $59T in dollars in the World, yet GDP was only $16.9T…lots of money not being spent…

…not to mention in 2013 the government spent $4.1T as private businesses invested $2.7T, so unless we assume every dollar of that spending went straight to savings, the existing (prior) savings cannot have contributed very much if anything to GDP.

People don’t spend their savings unless they have to.

Money doesn't "circulate" to any significant degree…it "settles" to the bottom (top).

Wednesday, June 5, 2013

Does Credit Drive The Economy Part II

As a follow-up to my previous post on the subject, I decided to try an alternative methodology that compares gross public spending and net private debt on an annual basis in analyzing the composition of new money creation. The graph is below. I tried to make it prettier than the previous one but I still haven't figured out how to reduce the number of decimal places on the Percentage axis (last time I did it manually…too time-consuming). It's a free program so I can't complain:

My observations…others may see more…

The peaks and valleys are more extreme, but they tend to oscillate around the 40% (average) level, just as the moving average in the original graph did.

For the years 2009 thru 2011 private debt went negative so the ratio can't be calculated. For the year 2012 private debt contributed about 5% to the new money total before taxes.

For the years that net private debt went negative (debt service exceeded new loans) private debt subtracted from total spending. What a drag!

The point that net private debt plunged drastically and went negative corresponds generally to the time the GFC hit.

Clinton's balanced budgets (or very nearly balanced) occurred in the years 1998 thru 2001. Spending declined drastically between 1992 and 1997, from $340B/year to $103B/year. These years correspond to a marked increase in debt issuance. We had headroom…we used all of that and then some.

That's about when banking policy enabled lending to borrowers that were marginal at best and uncreditworthy at worst…prudent underwriting was abandoned.

Conclusions…

We appear to be approaching a stable balance between debt service and incomes…I don't think we're quite there yet but at least debt service isn't dragging the economy down any longer. This doesn't mean borrowing will necessarily accelerate.

Private debt (mainly households) can drive the economy…into recession.

It's all on public spending from here on out.


Sunday, June 2, 2013

Does Credit Drive the Economy?

Much of the commentary on the economy seems to assume that it is driven by credit. The statement often made in blogs and news articles is that 90% or more of the money in circulation is private debt, the rest coming through net government spending, so clearly credit (debt) must be the main driver of the system. It's obvious. A caveman could see it.

I believe this is a gross mischaracterization of how the system actually functions.

Where do these claims regarding credit domination of the system come from? Is it truth or fiction. From what I had seen it was nothing more than an article of faith, I had never come across any proof or support that this was actually the case.

Based on the claims, the "money supply" people must be alluding to is the supply of dollars in existence within the domestic non-government. This is pretty simple number to figure out…

…The total level of state money in the private economy should be equal to all public spending plus all private debt outstanding less federal taxes and net exports.

All we have to do is compare the two sources of spending over time to get a handle on their respective contributions to the "money supply" that is being alluded to.

The solution requires downloading some data from FRED and making some necessary adjustments because some datasets are annual amounts and some are accumulations or running totals. The data we need:

1. FGEXPND - Current Federal Expenditures (Annual totals, must be converted to a running total (a balance) to be compatible with TCMDO). This is equivalent to adding a balance column in your checkbook.

2. TCMDO - Total Credit Market Debt Owed. Straight from FRED, a balance.

3. FYGFDPUB - Federal Debt Held by the Public. Also straight from FRED, also a balance.

Why do we need FYGDPUB? Because TCMDO includes public debt, which we must subtract to get to the total private debt.

The first step is to prepare the data and enter it into a graphing program. Converting FGEXPND to a running total gives us a series I've called rtFGEXPND.

TCMDO minus FYGFDPUB gives us a private-debt only series I have labelled pdTCMDO.

Next, we have to sum the two series rtFGEXPND and pdTCMDO to get the Total annual spending series.

Finally I created a series that plots Private Debt as a percentage of Total Spending. Note that it is not necessary to subtract federal taxes or net exports from the series to get the ratio, they merely reduce the level of money supply not the ratio between public spending and private debt. The relationships in equation form are:

Money Supply = rtFGEXPND + pdTCMDO

pdTCMDO(%) = pdTCMDO ÷ Money Supply

The graph of the result is shown below:



Since 1970, credit has accounted for between 36% and 47.5% of the total number of dollars spent into the economy (and bad things happened at that peak), currently standing at just under 40% of the "money supply". My seat-of-the-pants observation is that a healthy credit/public spending ratio is centered at no more than about 40%.

At no time in the past 43 years has credit ever accounted for anywhere near 90% of the "money supply". It's an urban legend.


Wednesday, January 9, 2013

Thought Experiment…a Credit-Based Economy

I've been shouting from the rooftops the fact (or what I consider a fact) that a monetary economy structured like that of the U.S. cannot run on a credit circuit alone, without fiscal support. I decided to construct a model that relates various components of a simplified economy and fund them with private debt to see if the paths of any components become unsustainable and if so, when?

To begin with I set up a circuit for which household income was identically equal to business expenditure, which has to be true in a closed system with no external sources of funding. The following assumptions were made:

• A gross profit target of 42% is assigned to the Business Entities (S&P average over the past several years).

• Both income and profits would grow at a rate of 4% (GDP growth).

• Any debt incurred to fund the system would be at 5% interest. Further, since there is a cross-section of maturities associated with household debt I derived a weighted-average or composite of payments in order to approximate overall debt service.

The debt-service calculation:


So, average household debt service is about 11% of the outstanding balance of household debt.

Next, I constructed a spreadsheet calculating two series over a 15-year period in order to graph the relationship between debt and income.

The Debt Series spreadsheet:


the debt service series was constructed as follows:

The accum column is simply the current year shortfall plus the accrued debt from previous periods.

In the first period debt service is calculated as one-half of the first years debt accrued.
The second period is calculated as 11% of the previous period accrued debt plus one-half (5.5%) of the current period.
The 3rd period is calculated as 11% of the previous balance plus one-half of the current period…
Repeat until completion.

Below is a chart of the result, illustrating the relationship between debt service and net income keep in mind all of the assumptions are conservative, meaning the chart illustrates a best-case outcome:

The first observation is that just beyond 9 years debt service completely overcomes income. Failure.

Practically speaking trouble begins when debt service is at 1/3rd of income…after about 4 years. Failure.

This doesn't look promising. Then we examine some likely realities:

1. The model assumes 100% efficiency in clearance of payments. Impossible. Fail.
2. The model assumes that 100% of participants would be willing and able to fund a significant portion of their lifestyle with borrowed funds, which they then would not be able to service. Impossible. Fail.
3. The model assumes that 100% of household would participate…if they didn't other households would have to take up the slack, which isn't possible. Fail.


All things considered this hypothetical appears to be a non-starter from the beginning with no possibility of success under real-world conditions. We must have fiscal spending for a monetary capitalist economy to function in a sustainable way. Why does anyone even bother trying to prove otherwise?

Further, if household can't afford to borrow funds necessary to purchase products, businesses in the aggregate will fail…there's no reason for businesses to take on debt to fund their operations. Business depends on fiscal…net fiscal…to succeed.

Question: is it a coincidence that when the level of $NFA held domestically lags the level of household debt by more than 5 years the lag correlates to financial crises?  Check it out:

https://dl.dropbox.com/u/33741/Debt_NFA%20series.png

Commence to tearing it apart!!!