Tuesday, 11 January 2011

Mistakes by the St Louis Fed.

This article by Michael Pakko of the St Louis Fed makes two mistakes. The first is a biggish mistake: a $340bn mistake, or thereabouts. But it’s a common mistake. It is as follows.

He claims two justifications for a deficit, i.e. a rise in the national debt. The first is that “ . . . deficits can be justifiable if they finance long-term expenditures (as with an individual who finances the purchase of a home)”.

The second is borrowing so as to fund Keynsian stimulus.

There is actually a third, which is the need to keep the monetary base expanding. The need for this constant expansion is down to two factors. First it is reasonable to assume the monetary base will expand in line with real economic growth, say 2% a year for the sake of argument.

Second, there is inflation to take into account. Unless the monetary base is constantly topped up, inflation will erode real value of the base (let’s say, again, at 2% a year).

An identical point applies to the national debt. To be more accurate, there is no “need” to keep the national debt at a constant level relative to GDP. But the reality is that while this debt is on the high side at the moment, it is unlikely to vanish altogether in the next ten years.

So let’s make the crude assumption that the national debt stays at a constant level, and equal to the average level over the last decade or so: roughly 50% of GDP.

Let’s also take the U.S. monetary base as $1trillion (about 7% of GDP): that’s where it was roughly 18 months ago before the very large spike caused by bank bailouts, quantitative easing, etc. Let’s say GDP is $15trillion.

Taking the above back of the envelope figures, the deficit required to keep the monetary base and national debt expanding along with real GDP will be:

(2% + 2%) x (50% + 7%) x $15trillion = $340bn (unless I’ve made a mistake!)

The second mistake in the Fed article is the claim, mentioned above, that “ . . . deficits can be justifiable if they finance long-term expenditures (as with an individual who finances the purchase of a home)”.

Not true. Indeed, “individuals who finance a home” and businesses who borrow to invest seem to have got their heads screwed on tighter than governments in this area, and for the following reasons.

The REAL purpose of a loan is to cover expenditure which the borrower cannot possibly meet from their own resources. E.g. if you’ve got at least $30,000 in the bank and want to buy a $30,000 car, there is no obvious reason to borrow the $30,000.

Now governments make investments every year which are of monumental proportions compared to investments made by the average firm or household. But then government INCOME is monumental as well.

In other words governments can perfectly well fund ALL their investments out of income. Indeed, taking the simple example of where a government invests exactly the same amount each year, and funds this out of borrowing which it gradually pays back, this government will end up paying out EXACTLY THE SAME AMOUNT of money each year as if it had funded investments out of income. The only difference is that under the borrowing scenario, interest has to paid.

To summarise, the fact that $X of a deficit is spent on investment does not justify that portion of the deficit, at least not on the basis of Pakko's argument. There may of course be justifications for government borrowing so as to fund investments, but if they exist, they are more abstruse and complicated than the above one.

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