Washington Has a Critical Thinking Problem
So the "fiscal cliff" crisis has been postponed and the debate continues about how Republicans and Democrats want to narrow the deficit. The left wants to include some higher taxes. The right wants to achieve it through spending cuts and, possibly, closure of some tax loopholes. Both sides are looking for answers, but they've asked the wrong question.
The real question -- the one that should be answered first -- is, "What size should the deficit be, given our current circumstances?" Even better would be the question, "How can we set our laws to ensure our federal deficit (or surplus) comports itself to the needs of our economy now and as conditions change in the future?" Instead, what we have is a question born out of irrational fear: "How drastically and by what means should we cut the deficit?" I believe this fear comes from misunderstandings about the role of the federal budget deficit and federal debt in our economy reinforced by prominent (which is not to say correct) economists and business people who see opportunities for profit in suffering.
The federal debt and federal budget deficit are, without question, big numbers. I think, though, that it is the concept of debt -- linked, out of our personal experiences, with worry -- coupled with these large numbers that produces our collective, national fear. The antidote to that fear is understanding: understanding what the debt means, why it was accumulated, and why we need not fear about defaulting on it.
First, the largest number: the debt. Every dollar that the federal government spends in excess of the amount of taxes collected (also called "net spending"
has, customarily, been "financed" through the sale of Treasuries (bonds, notes, and bills). These instruments, until maturity, represent an obligation of the United States government to deliver certain numbers of dollars to the holder at certain times and, as a whole, constitute our federal debt. Almost every dollar of this net spending went into the hands of an American person or corporation. In short, nearly every dollar of government net spending resulted in private, American wealth (although some leakage to foreign consumables probably occurred later).
So now we hear that we should work to reduce the national debt, because that debt is somehow "bad." There is one simple way to reduce the debt: coin new money. This would have a two-fold effect: the coined money could be used to directly retire some of the debt and the inflation caused would decrease the real value of the debt remaining. Of course, that same inflation would hurt any holder of US dollars, anyone who lent dollars expecting low inflation and anyone who borrowed heavily at a variable rate. The only other source available to pay down the national debt is the private wealth it was used to create. And you can bet that it won't be the wealthy and extremely wealthy of this country shouldering the lions share of that pain -- it will be the middle class.
Why is national debt "bad?" A family or business in debt has to make regular payment to service the debt or risk collection proceedings and bad marks on their credit that can cost them even more in the long run. If that family or business runs out of money before the debt service is paid, it is insolvent and bad things start happening. Any private debtor can, sometimes through no fault of their own, run into this situation, which is why taking on such debt is always somewhat risky. But public debt is different because of a power the federal government has which families and businesses lack: the legal right to create as much money as it chooses. The government creates money not through taxes (which actually destroy money) but by law (although the actual process does use coins). We no longer, thank God, use a commodity-based currency (since 1971); our currency is now backed by the value of "not going to jail for unpaid taxes." So there is no real danger of insolvency for our federal government, contrary to the claim frequently made by more conservative politicians. We have public debt because we choose to, not because it is necessary. It can't be that bad, or we'd have gotten rid of it already.
With that knowledge about the nature the federal debt, let's look how it came to be: the federal budget deficit and Congress's "financing" practices. In most years, the US Federal Government, through appropriations bills passed by Congress, has chosen to spend more dollars than it received in revenues (mostly taxes). Rather than coining new money, Congress chose to "finance" this spending by borrowing dollars with a promise to repay them with interest. Most economists recommend this to prevent inflation, since coining new money increases the money supply (which may bring images of money-dropping helicopters to mind). Congress's net spending is not, however, like helicopters dropping money because it buys goods and services that would otherwise not be produced or provided. Thus, the net spending is not inflationary. In fact, if anything is inflationary, it is the interest offered on Treasuries -- money spent only to keep other money out of circulation.
If Congressional borrowing is not necessary for deficit spending, then why do they do it? Looking in depth at our banking sector we can see the role that Congress's "financing" really plays: it provides a way for banks to earn money on excess reserves that wouldn't make as much return in the interbank reserve market. Were Congress to coin money without taking on debt, the money would be deposited with banks. Part of these deposits become excess reserves -- reserves the bank could lend out to other banks finding themselves short of reserves. But these reserves entered the system, increasing supply, without any matching increase in demand. Classic market economics tells us that the price/profit on the loan of reserve funds will go down in this case. If they rate slips low enough, and if Congress is borrowing money, the bank can choose the returns guaranteed by Treasuries over the lower return of the reserve market. In fact, if Congress net spent without full financing, the reserve situation would look much like Japan in, to pick a year, 2010 -- with excess reserves earning almost no interest.
So, not too surprisingly, the "financing" of our federal budget deficit is mostly a handout to the banking industry. It does also benefit people looking for risk-free investments -- like workers near retirement age. Alternatives would be needed if our country decided to entirely forgo borrowing. But the banking industry likes the status quo, so their big money funds the economics departments and think tanks insisting that "printing money" will cause rampant inflation; that story consistently drowns out the alternative analysis. The worst part of it is that politicians are either not hearing this reasoning about our debt and budget deficit, not believing it to be correct (because their experts, endorsed by the bank-owned economics establishment, tell them so), or because they don't think they can sell it to the public. They don't realize how important it is to do the critical thinking exercise about our economic situation themselves and, if necessary, educate the public to the realities.
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