The key to deficit reduction is distinguishing between the structural and the stimulus deficits.

Summary.

The debt and deficit (DD) are made up of two elements. First, there is the structural DD. This derives simply from failure to collect enough tax to cover government spending. Second, there is DD which derives from stimulus.

Disposing of the structural DD is easily done by reversing the process which brought it into being. The process that brought it into being consisted of collecting insufficient tax to cover public spending, and having government borrow instead. So reversing the process consists of raising taxes and paying back creditors. In a closed economy no “pain” or “austerity” is involved here because the “pay-back” consists of nothing more than shuffling assets and liabilities between different groups of citizens. Those assets and liabilities net to nothing.

As regards the stimulus DD, the DEFICIT cannot be removed as long as stimulus is required. But there is no need for the DEBT to increase in consequence. As Keynes, Milton Friedman and numerous other economists have pointed out ad nausiam, deficits do not need to accumulate as debt: they can perfectly well accumulate as additional monetary base.

Conclusion: reducing the national debt is not difficult. To take the extreme case, reducing it to zero in a few years is perfectly feasible.


The flaws in popular DD discussions.

A mistake made by a large majority of those commenting on the DD in the U.S. and U.K. is the claim that the DD is best reduced by raising taxes or cutting public spending. In fact the Bowles-Simpson report is little more than a list of possible spending cuts and tax increases, as is a paper by Nobel Laureate Joseph Stiglitz.

Well the big problem here is that tax increases and public spending cuts raise unemployment!!!!

The advocates of increased taxes / public spending cuts are of course aware of the employment implications, but they get round the problem by assuming or hoping that the economy will recover at some stage.

That, frankly, is a bit feeble. We’ve moved on hopefully from the 1920s when it was thought that governments could do nothing about unemployment. That is, it is now generally accepted that they can do something. So what we need to hear from the likes of Bowles-Simpson and Stiglitz is how they propose maintaining employment while reducing DD and assuming the economy DOES NOT recover on its own. And we particularly need to hear this message in view of Keynes’s claim that economies can take an excessively long time to recover from recessions without government assistance.


“Pain” and “austerity”.

Another popular piece of nonsense is that cutting the DD involves “pain”, “austerity” and the like. Bowels-Simpson claim on page 4 of their report that “the Solution Is Painful”. And the Brookings Institution claims “The solutions to this problem will be painful and divisive.” And Stiglitz claims that significant amounts of austerity are involved (1st para).

As pointed out in the summary above, in a closed economy, no austerity is involved. In contrast, where other countries hold a significant proportion of government debt, some austerity might be involved. But more on that below.


The distinction between debt and deficit.

The distinction between debt and deficit is blurred here. This is because the deficit reduction policy advocated here is very flexible. That is, the policy could be used simply to reduce the deficit a little, while the debt continues rising. Or at the other extreme, the policy could be applied in large doses, which would result in actual debt reduction.


How to reduce the structural DD: just reverse the process that brought it into being!

A structural DD consists, to repeat, of government spending more than it collects in tax, so it borrows to compensate. Reversing this process simply consists of government raising taxes and repaying creditors (quantitative easing, in effect).

It is important to note here that so far as structural DDs go, there is, by definition, no effect on aggregate demand. In other words the deflationary effect of the above extra tax must equal the stimulatory or inflationary effect of the QE. And it is likely that the amount “QEd” will be much more than the amount involved in the above tax increase. Reason is that borrowing is not all that deflationary.

That is, when government borrows, it takes cash off the lenders, but the lenders get bonds in return (Treasuries in the U.S.). So the lenders are scarcely any worse off. Bonds are not quite as liquid as cash, so demand declines A BIT. But I’d bet my bottom dollar that the deflationary effect of government borrowing, dollar for dollar is much less than the stimulatory or inflationary effect of the average dollar of government spending.

At any rate, assuming government manages to get the inflationary effect of the QE equal to the deflationary effect of the extra tax, the net effect is neutral. That is, GDP shouldn’t change. Aggregate demand does not change. Total numbers employed do not change.

WITHIN the above aggregate “non-changes”, there is an important shift of income from low income groups towards the better off (i.e. bond holders). This effect lasts as long as the QE lasts. But that undesirable effect can always be countered by shifting the burden of tax from poor to rich. Given that Warren Buffet’s secretary allegedly hands over a larger portion of her income to the tax authorities than does Warren Buffet, there is, to put it mildly, scope for taxing the rich a little bit more.


Pain and austerity.

As pointed out above, some pain is involved in that a country is an open economy and for the following reasons. QE involves giving bond holders cash in exchange for their bonds. A proportion of those former bond holders will in consequence find they have more cash than they want. Thus they will seek alternative investments, a proportion of which will be outside the country. Possibly this applies particularly to foreign governments which hold the bonds of other countries (e.g. China’s large stock of U.S. government bonds). Anyway, the net effect of QE is to depress the value of the currency of the debtor country. And that means a small standard of living hit for the country concerned.

Indeed, the result of American QE in the last two years or so has been a substantial flow of dollars into countries which have not really welcomed this inflow.

But as regards a fall in the value of a country’s currency, the pound sterling lost about 25% of its value in 2008, and the response of the British population has been one big yawn. Certainly the standard of living hit has been nothing like the hit taken by residents of Ireland, Portugal and Greece recently (largely and ironically as a result of their INABILITY to devalue their currency).


The stimulus deficit.

As mentioned above, the stimulus deficit cannot be reduced so long as stimulus is needed. But the main concern that “DDphobes” have about deficits is the rising debt they cause. Well there is a simple solution to this non-problem which has been pointed out over and over again by economists for getting on to a century now. This is simply to have the deficit accumulate as extra monetary base instead of extra debt. E.g. see 1. Milton Friedman (p.250), 2. Keynes (2nd half of 5th para), 3. Claude Hillinger (p.3, para starting “An aspect of…”) and 4. Warren Mosler (2nd last para).


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