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).