Getting serious about debt and deficits: the deficit hawks did enormous harm to our kids
from Dean Baker
Debt and Deficits, Again
With the possibility that the Democrats will retake Congress and press demands for increased spending in areas like health care, education, and child care, the deficit hawks (DH) are getting prepared to awaken from their dormant state. We can expect major news outlets to be filled with stories on how the United States is on its way to becoming the next Greece or Zimbabwe. For this reason, it is worth taking a few moments to reorient ourselves on the topic.
First, we need some basic context. The DH will inevitable point to the fact that deficits are at historically high levels for an economy that is near full employment. They will also point to a rapidly rising debt to GDP ratio. Both complaints are correct, the question is whether there is a reason for anyone to care.
Just to remind everyone, the classic story of deficits being bad is that they crowd out investment and net exports, which makes us poorer in the future than we would otherwise be. The reason is that less investment means less productivity growth, which means that people will have lower income five or ten years in the future than if we had smaller budget deficits. Lower net exports mean that foreigners are accumulated U.S. assets, which will give them a claim on our future income.
Debt is bad because it means a larger portion of future income will go to people who own the debt. This means that the government has to use up a larger share of the money it raises in taxes to pay interest on the debt rather than for services like health care and education. Or, to put it in a more Keynesian context, there will be more demand coming from people who own the debt, which means the government would need higher taxes, to support the same level of spending, than would otherwise be the case.
There is an important intermediate step in the deficit-crowding out story that is worth stating explicitly. The Federal Reserve Board could opt to keep interest rates low by buying up debt directly. The assumption in the crowding out story is that the Fed allows interest rates to rise or even deliberately raises them, presumably because it is concerned about inflation.
If there is no basis for inflationary concerns, there is no reason that the Fed could not simply keep interest rates low in spite of a large deficit, and therefore prevent any crowding out. The question then is whether a budget deficit is pushing the economy up against its limits, leading to inflationary pressures. When we look at the various sources of demand in the economy, there are two reasons for thinking that a larger budget deficit would be needed today to sustain something close to full employment than would have been true four decades ago.
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Real-World Economics Review Blog 
The Reps are ignorant and care only about debt when it means any care for people not members of the class/elite corporate bosses. Henry Ford explained long ago; Americans have no idea that Banksters print the money (not the Treasury/people, who pay interest on their own money)
I suspect the moneyed folks anticipated this. In their medieval order all life is a series of jousts which they intend to mostly win before retiring to one of their castles or…now…yachts.
Very sharp Dean Baker at his best. I particularly appreciated relating taxation level to increased debt payments, as it reduces effective demand via redirected income to debt holders. Even so, this mature economic thought process far eclipses Krugmanesque notions of engineering inflation to devalue the debt until it is no longer bothersome.
“…the classic story of deficits being bad is that they crowd out investment and net exports, which makes us poorer in the future than we would otherwise be. The reason is that less investment means less productivity growth, which means that people will have lower income five or ten years in the future than if we had smaller budget deficits.”
A very real economic issue of deficits relates to communication of full awareness between buyers and sellers as a necessary conditional foundation of free markets. This is where a fully functional democracy is shown as entropic prerequisite to a free market via information flow.
Deficits expressed as mathematical sums miss the decision process and information flows leading to the specific deficit expenditure. Here is a door economists have been reluctant to open.
It is one thing to incur a greater deficit if hurricane season outstrips reserves set aside for emergencies and the budget is already a tad on the deficit side for reasons previously hashed out by distributed human intelligence applied in some rational way beyond the problem of representative democracies representing capital rather than people.
Deficits present an entirely different facet when a corrupt government buys things it doesn’t really need from capitalist cronies upon receiving a kickback from golden sacks. Here we see information flows disrupted to the detriment of the future even though the deficit boosts effective demand in the present. This is a key economists will use soon or there will be increasing chaos in a less and less free market, even if the market appears well regulated operationally.
“Debt is bad because it means a larger portion of future income will go to people who own the debt. This means that the government has to use up a larger share of the money it raises in taxes to pay interest on the debt rather than for services like health care and education”
Taxes are not revenue. Your entire premise is wrong.
Boz, in courses on public finance which I give taxes are indeed revenue. How do you handle them in your courses?
If I understand him, Boz is basically right, although he may not realize that Dean Baker is actually critical of what he quotes. Baker is just presenting the (incorrect) mainstream story there. In reality, the government cannot and does not “raise money” when it taxes. Taxation destroys money. It is not a source of money to the government.
But actually the word “revenue” (or “tax return”) is correct and enlightening. Revenue comes from French Re + venir. To come BACK. The money that the sovereign issued is returned to the sovereign – and cancelled, erased. Two oppositely directed credit/debts – the tax bill and the money – are cancelled against each other. Neither exists except as a memory after that.
It is important enough to understand that actually big debts can be “bad” – just a little. The correct theory does contain the mainstream observations- but the mainstream wildly, wildly exaggerates them. Abba Lerner, responding somewhat to Seymour Harris’s mild criticisms in his book on The National Debt, did outline in papers in the late 40s and in the appropriate chapter of his Economics of Employment roughly what Baker is saying, although Lerner made it clearer how minor and unavoidable the negatives of a big national debt are. (He wasn’t worried about a Debt/GDP ratio of even 3000% or so.)
For a while, Abba Lerner, following Keynes & others, did convince everyone of the absurdity of the mainstream theory of the National Debt. But then James Buchanan & later purveyors of the nonsensical “Government Budget Constraint” managed to convince everybody that black was white, that scrambled eggs jump out of frying pans and put themselves into shells, again, through what Lerner himself criticized as “word-play”. (or something similar)
The fact that the neoclassicals have a theoretically and empirically incorrect model of the impact of the debt and deficits is not an argument for high deficit spending. It just means their model is wrong. It is difficult to find a more dangerous area in economics where the impact of ideas could potentially lead to disaster. Poorly thought out free trade ideas sold as policy has displaced many and caused permanent change to the society. I am not aware of any convincing and empirically defensible structure for the relationship between the deficit, debt, yield curve and spending. In Dean’s paper, one concern would be his second to the last paragraph where he says the Fed could keep interest rates low by purchasing debt. That is using neoclassical supply theory in a Keynesian argument. If future huge debt leads consumers to question the currency, Fed purchases ballooning excess reserves might itself cause the yield curve to rise and so have the opposite impact. I am guessing that we are years away from that, but that is exactly the problem in that it is a guess. The free trade argument was very convincing at the time also and it took a few decades to do its harm.
If future huge debt leads consumers to question the currency, Fed purchases ballooning excess reserves might itself cause the yield curve to rise and so have the opposite impact.
This is either ill-stated or simply impossible. The Fed can and has completely controlled the yield curve. The rest of the world has zero power against that. They can choose to buy or not buy US debt, hold or not hold US dollars. The foreign or domestic value of the US dollar can vary, but the rest of the world has no more power over US debt interest rates against the US government than it has about whose face is on a ten dollar bill, or that ten dollar rather than the much superior thirteen dollar bills are issued.
The Fed does not completely control the yield curve. It controls short term rates such as the federal funds rate, and influences the long term rates periodically. Influence is not control. Quantitative easing during the financial crisis represented trillions of dollars spent and by the Fed’s own research only reduced long term rates by about one percent. The process had only limited success, it was a temporary operating measure, and has since expired. And anyway, I was referring to potentially dysfunctional results in a financial crisis in which the markets may act in a very different pattern than expected.
First of all government debt is smallish in comparison to total private debt which is where the real problem lies because even though it has fallen from like 180% of GDP at the height of the crisis to somewhere north of I believe 130% now which means that as the rate of change of credit goes up (as it must or recession will occur) there is less and less “wiggle room” for debt to build back up to a crisis point. The system as it is IS financially unstable AND still sitting on mountains of debt. We must borrow continuously to avoid recession and yet continuous debt build up to the point of un-servicability will result in recession or worse….so we’re “stuck between a rock and a hard place” as the saying goes. Throw in no realistic or stabilizing financial regulations and the disruptive force of AI on aggregate demand/individual incomes….and it’s astonishing to me that we’re here parsing economic theories and obsessing over its minutiae instead of taking proactive, ney, paradigmatic actions.
Even Steve Keen whose unconscious re-discovery of the economy’s cost inflationary nature (the unstable state described above where financial costs continually build up) calls only for “a modern debt jubilee” which is a one-off static palliation of the problem and has been practiced by elites repeatedly over the 5000 year old course of the current paradigm of Debt Only for the form and vehicle for the creation and distribution of money. This palliative static policy stance is curious to me seeings how Keen is (correctly) adamant to de-bunk DSGE.
No, we require a dynamically ongoing, direct, integrated, effective and paradigm changing set of policies that inverts the problematic cost inflationary nature of modern economies and so effects an actual solution its deepest problems.
That paradigm is Direct and Reciprocal Monetary Gifting.
Craig, I agree private debt is the issue. In Europe governments have often taken over bank debt, since investors knew they can receive a portion of that back, unlike private debt where the debt-holder can walk away. With many more poor-paying & temporary jobs now among us, and new debts being incurred by the happy new jobholders, we certainly will see more problems. And then there is the Trump tariff fiasco which will start hurting everyone shortly, I expect.
This post illustrates well many of the basics of science as a cultural artifact. In dealing with deficit science, a part of the social science called economics it demonstrates how such science is created, justified, and applied. It also shows how science increases its chances to convince people to accept it as true or real. And to adhere to, if not wholly at least in part the details of the story propagated by scientists as true and correct, and sometimes accept the story as a law. It also shows the conflicts that develop when parts of the story are challenged by offering alternative stories. On the last the post provides details on how the supposed fixed relationships that make up the scientific theories that are peddled by some scientists as unquestionably true can be challenged by simply refusing to accept these supposedly “fixed” relationships. Here the story shows us that such stories are made of stories linked to other stories. Held together with various types of cultural glue (e.g., reputations of scientists, mathematics, and of course threats and bullying). The post also points out that changes in some situations external to the scientific story can render that story less relevant or even irrelevant in describing and understanding peoples’ actions and the claimed motivations for them. The post shows us science for what it is – a cultural assemblage of materials, ideas, institutions, assertions, and rhetoric intended to move people along a specific path for certain purposes.
Ken, one of the real aspects of America’s easy credit/easy re-establishment of credit is a natural tendency over time to all but ignore it, even with consumers who have no pressure to take risks to make a firm succeed. In my global travels these many years, I often encounter Americans who are running either from the tax or debt collector. Let’s face it, credit & its opposite, debt, are an integral part of global society.
James, little doubt you are correct. Debt has been part of human culture for over 5,000 years. The standard theory to explain this is that debt in linked to the government creation of money and taxation. Debt was the obligation to use money pay government taxes. This approach seems ridiculous to me. It assumes that from the beginning all governments were autocratic maniacs interested only in collecting taxes. And that with the obligations of debt members of society paid these taxes with no complaints. I prefer what’s called primordial debt theory. The core argument is that any attempt to separate monetary policy from social policy is ultimately wrong. Primordial-debt theorists insist that these have always been the same thing. Governments use taxes to create money, and they can do so because they have become the guardians of the debt that all citizens have to one another. This debt is the essence of society itself. It exists long before money and markets, and money and markets themselves are simply ways of chopping pieces of it up. These obligations are reflected in every world religion. For example, ancient Indians teach that to be in debt is to have a weight placed on you by Death (Yama, god of death). Perfect for a communal species.
Debt has evolved into credit, particularly in the west. The most important of those changes’ is usury, the charging of interest on money lent. Religious teachings indicate lenders should treat borrowers, members of the community. Money lending from the earliest of times seldom fit this archetype. Often this was the result of money lenders being frequently from other nations or groups (e.g., in Europe often Jews played the role of money lender). But usury was banned or not approved of in almost every society on earth. That began to change in the last several hundred years. For example, in the US the erosion of state usury laws reflected the new attitude that had been developing toward debt since the 1970s. Debt was no longer feared. The term had been replaced in consumer culture by the term credit; how much credit lenders extended to borrowers reflected the borrowers’ status in life, not a potentially damaging tool that could alter the borrowers’ lifestyles and prospects. Debt was being accumulated at a fast rate, suggesting that consumers either were borrowing with a high degree of certainty about their future earnings prospects or were being sold a financial product with which they were not familiar. Decades of finance theory and political ideology combined to relegate worries about the absolute levels of interest rates to the back burners. Real rates of interest were more important than absolute levels. Portfolio theory assumed that poorly rated debt could enhance the yield on a fixed income portfolio, justifying its issuance in the first place. Securitization had made credit generation easy, especially for institutions outside traditional banking known collectively as the shadow banking system. And bankruptcy had become somewhat predictable. Models could predict a corporate bankruptcy with a high degree of confidence. Debt was no longer the bête noire in the financial jungle; now it was just another financial tool.
This paragraph above on economics and science Ken wrote really nailed it. This is exactly the problem I see in not just Dean’s post but in policy in general. Dean is advocating continued deficit spending, but based upon what? That neoclassical theory is wrong? That is not a reason for spending. Is he advocating deficit spending based upon the idea that nothing has gone wrong yet? Is that sufficient reason? Dean says deficit hawks have done enormous damage. Well, where? Please show me. The deficit and debt is now rising quickly but why do we need to have such stimulus with a low unemployment rate and decent growth? There are clearly very serious issues of income distribution in this country but I fail to see how running huge deficits would address it. So, where is the science for arguing for continued or increased deficit spending? What are the equations? Or is this just a call for deficits because nothing seems to have gone wrong yet and inflation and interest rates have not reacted badly yet. Is that science? Is that sufficient reason to make a multi-trillion dollar decision?