Tuesday, 16 December 2014

A deficit should never increase the debt.

Alternative title: The popular idea that public investments should be expanded while interst rates are low is invalid.
Summary (in purple).
The purpose of a deficit is, or should be to impart stimulus, and deficits do that by, amongst other things, increasing private sector paper assets – specifically base money. That increased stock of liquid assets induces the private sector to spend.
The AMOUNT of deficit needed is whatever overcomes the private sector’s desire to save or hoard base money – i.e. saving money causes excess unemployment, as Keynes pointed out. But base money on which interest is paid equals government debt, as pointed out recently by Martin Wolf, and the higher the interest offered, the more will be saved.
But what’s the point of that interest when the only effect is to induce more saving? It’s completely, totally, 100% pointless: the only net effects are to burden the taxpayers who fund the interest, and benefit the rich (those who hoard base money). Ergo a deficit should and will cause the stock of base money (aka bank reserves) to rise, but there is no excuse whatever for it causing a rise in the debt.
The only possible exception to the above rule comes in as far as a deficit funds infrastructure or other public investments: that’s an old idea sometimes called the “golden rule”. That rule was recently endorsed by Ed Balls. In fact that public investment so called exception is almost irrelevant. Thus the above rule that a deficit should never increase the debt is near watertight.

The purpose of a deficit is to make up for inadequate private sector spending: that is, if private sector spending is not enough to keep the economy working at capacity, demand needs to be increased by having government spend more than it collects in tax.
But the only possible explanation for inadequate private sector spending is a desire by the private sector not to spend! (Forgive the statement of the obvious). That is, the explanation must be a desire by the private sector to save money rather than spend it. Indeed, the latter point is simply a re-statement of Keynes’s “paradox of thrift”: that’s the idea that while thrift is in a sense desirable, hoarding money does have an undesirable side effect, namely that it reduces demand (assuming the saved money is not loaned out and spent).
Now of course the amount the private sector wants to save / hoard is influenced by interest rates: the higher the rate of interest, the more people will save. But normally central banks do not offer interest on money lodged with them: i.e. they don’t pay interest on reserves, and quite right.
Indeed, if interest IS OFFERED on base money, then that base money in effect  becomes government debt. Or as Martin Wolf put it, “Central-bank money can also be thought of as non-interest-bearing, irredeemable government debt. But 10-year Japanese Government Bonds yield less than 0.5 per cent. So the difference between the two forms of government “debt” is tiny…”
Indeed, paying interest on base money / government debt is totally and completely pointless, at least where the purpose of that base money is to impart stimulus. The only net effects are, 1, to place an extra burden on taxpayers who fund the interest payments, 2, subsidise the rich (those who hoard base money), and 3, increase the total amount of base money that has to be issued.
Incidentally, it should of course be said that deficits don’t cause increased demand JUST because private sector paper assets are increased. There also the fact that where government spends more (e.g. on health and education) that will increase employment in schools and hospitals. Alternatively, to the extent that government effects the deficit via tax cuts, then increased household after-tax incomes will increase household spending.

A possible exception to the above rule that a deficit should never increase the debt comes with public investments, like infrastructure.
It is widely believed that government investments should be funded by government borrowing rather than by tax. In fact that point is debatable. Kersten Kellerman (1) argued in a paper in the European Journal of Political Economy that public investments should be funded by tax, not public debt.
However, it doesn’t matter for the purposes of the argument here whether public investment is funded by tax or borrowing. Assume they’re funded by tax if you like. Alternatively, assume they’re funded via borrowing, with the rate of interest paid being the same as would be paid to a private contractor who provided the relevant assets / investments.
Note that if those investments ARE FUNDED by debt, the total size of that debt will remain pretty well fixed because the total amount or value of public investments relative to GDP does not vary much from year to year, or even from decade to decade. And since stimulus is all about VARIATIONS in the amount of debt / base money, public sector investments won’t have much to do with stimulus.

Expand investment in a recession?
A possible objection to the latter point about raising public investments in a recession is the popular idea that it’s positively DESIRABLE to expand public sector investments in a recession. Unfortunately there is a shortgage of “shovel ready” schemes.
Worse still, even if some of such schemes CAN BE started quickly, it can take several years, even DECADES to complete such schemes: by which time the next recession will probably have come and gone, which makes those investments a very inappropriate way of dealing with recessions.
In short, it’s CURRENT spending, not CAPITAL spending that needs to be boosted in a recession.

Raise public investments while interest rates are low?
Let’s assume that public investments are funded by borrowing rather than by tax. I suggested above that interest should be paid on the relevant public debt, but that interest should not be paid on base money. Now an obvious problem there is that holders of base money will buy public debt in large amounts: why get zero interest on money you’ve placed with government when you can get interest?
That in turn tends to depress the rate of interest on the debt: indeed many governments can currently borrow at ultra-low rates. However, that low rate on public debt only exists because government stands behind the debt, and governments are EXTREMELY credit worthy compared to private corporations in that governments can grab any amount of money from taxpayers even if the investments made by government are a disaster.
In short, the low rates of interest at which government can borrow stem largely from the coercive powers of government. Those powers are not a realistic basis for making decisions about which investments are viable or whether the total amount of public investment should be expanded.
And a final reason for ignoring low interest rates when it comes to funding public investments is that adjusting interest rates is not a good way of adjusting demand for reasons set out here.


1. “Debt financing of public investment: On a popular
misinterpretation of “the golden rule of public sector borrowing””. European Journal of Political Economy.


  1. Correct - Keynesian fiscal stimulus, quoting from Musgrave above:
    "where government spends more (e.g. on health and education) that will increase employment in schools and hospitals. Alternatively, to the extent that government effects the deficit via tax cuts, then increased household after-tax incomes will increase household spending"
    Wrong - monetarist claptrap:
    "increased stock of liquid assets induces the private sector to spend"
    Changes in base money and/or the broader money supply is NOT an alternative to fiscal policy. It is is merely an incidental consequence/side-effect of fiscal deficits and growth.
    There no evidence that QE (an increased stock of liquid assets largely held in bank reserves) has stimulated spending to a significant extent. And Friedmanite monetarist policies proved ineffective, indeed disastrous, in the UK and USA in the 1980's.
    In contrast, there is tons of evidence that fiscal measures (government expenditure and taxation) work.

    1. QE is wholly different to my “money supply increases the stock of liquid assets” point. £X of QE has little effecet on the stock of liquid assets assuming one counts government debt as liquid, and it is relatively liquid. Indeed Martin Wolf in the quote which is in the right hand column at the time of writing said there’s almost do different between base money and debt in Japan. Put another way, QE, as has been pointed out by thousands of other people, is simply an asset swap.

      In contrast, £X of “new money funded fiscal policy” increases liquid assets by £X, and not a penny less.

      As to Milton Friedman, I agree he went too far in saying that an economy can be regulated SIMPLY BY regulating the amount of money. On the other hand, it is clearly nonsense to claim that that quantitity has no effect at all. What do people do when they win a lottery?

  2. "normally central banks do not offer interest on money lodged with them: i.e. they don’t pay interest on reserves, and quite right".

    In recent years the CBs of the USA, UK, Sweden, Denmark, Turkey, Canada, Italy and maybe some others pay interest on reserves. In some cases the interest rates are negative!
    Cochrane has a paper on this:
    Personally I don't entirely agree or follow everything he writes here regarding macroeconomics, but
    one of his conclusions reaffirms his earlier support of Full Reserve banking):
    "by keeping a large balance sheet and encouraging 100% backed institutions to drive out run-prone inside money, the Federal Reserve could do a lot more for financial stability than its current massive regulation and crisis lending, bailing out, and asset-price propping up activities".


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