Friday, 12 November 2010

Obama’s Debt Commission is clueless on the basic nature of national debts, deficits, etc.

The Debt Commission, which is trying to produce a plan to reduce the national debt, has just produced a draft report. It’s in nice big bold type, so economic conservatives may be able to understand it. Unfortunately some of the words have more than one syllable: possibly a problem for economic conservatives.

Essentially the report is nothing more than a list of possible government spending cuts and possible tax increases. Well obviously those two will reduce the deficit. And if the spending cuts / tax increases go far enough, the national debt is also reduced.

But there is a problem: spending cuts / tax increases destroy jobs, and that is exactly what is not needed just now. So what to do? Well here’s the answer.

If a government spends more than it collects in tax, obviously that means a deficit. And the deficit can be funded in two basic ways. First, government can borrow, and that increases the national debt. Secondly, it can just let the monetary base increase. Essentially the latter option just consists of the government / central bank machine printing and spending newly created money. Indeed this money printing is exactly what has happened big time in the case of Quantitative Easing (QE).

As regards borrowing, there is a big potential problem, as follows. Borrowing $Xbn from the private sector, and then letting the money flow back into the private sector in the form of $Xbn of government spending means that the amount withdrawn from the private sector equals the amount “given back”, so to speak. It is quite possible that the net effect is ZERO. At least there is certainly some argument as to exactly how big the employment boosting effect is.

A better option (the one favoured by Keynes) is the second one: plain straightforward money printing. Certainly this second option is a good one where the national debt looks like growing too large.

And for those who want to give the usual knee jerk reaction to the money printing idea, i.e. “Weimar”, “Mugabwe” and so on, perhaps they can tell us why the U.S. monetary base has increased by astronomic and unprecedented amounts over the last two years (as a result of QE), yet inflation is at a near record low.

The explanation, of course, is that money printing will not be inflationary UNTILL the private sector decides it has too much money and starts spending excessive amounts. That drives up demand, which in turn creates jobs, and if it goes too far, drives up inflation. And at that point, it may very well be necessary to “unprint” money: i.e. have government raise taxes, rein in money and extinguish it.

Of course money printing is not without inflationary risks. But all governments are constantly caught between a rock and a hard place: too much demand and inflation becomes excessive, while too little demand means excessive unemployment.

Having said that money printing is the way to reduce the deficit while not destroying jobs, it is legitimate to ask why QE has involved money printing big time, yet the employment boosting effect has been pathetic. The answer is simple: the additional money has gone into the pockets of the section of the population least likely to spend it, that is the wealthy.

And there is a second reason why QE has had little effect, as follows. Had there been a straightforward helicopter drop of bundles of $100 bills into the gardens of wealthy, there might have been an effect. But what QE actually involves (to put it figuratively) is taking $X worth of valuable bits of paper called “Treasuries” from the wealthy, and giving them $X worth other other bits of paper called “dollar bills”.

Now why should that have any effect? It’s a bit like confiscating red and green Rolls Royces from the wealthy, and giving them grey and brown Rolls Royces in return. That would produce a lot of yawns, but not much else.

Government spending as a proportion of GDP.

Another mistake the commission makes is to get politics and economics mixed up, in particular, they claim that cutting government spending as a proportion of GDP will reduce the national debt. (See p. 6). They actually advocate cutting the proportion to 21%.

Perhaps they can tell us how come several European countries over the last fifteen years have had government take DOUBLE that amount of GDP, while at the same time keeping national debt CONSTANT as a proportion of GDP over a period of several years.

The answer, of course, is that the deficit has ABSOUTELY NOTHING to do with what proportion of GDP is taken by government. For example if government spends 2% of GDP while its income from taxaton is 1% of GDP, then the deficit will be 1% of GDP. Likewise if government spending is 41% of GDP and its income is 40%, then the deficit will still be 1%!!!!

Moreover, the decision as to what proportion of GDP is taken by government is the basic difference between the political left and the political right. It is not the job of a supposedly apolitical body like the Deficit Commission to have an opinion on this matter.

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