By Ben Strubel of Strubel Investment Management
Numerous quotes, commentaries, presentations, and letters by some great investors, such as Whitney Tilson, Howard Marks, and Arnold van den Berg, discuss the deficit, national debt, and the “unfunded entitlement” problems that are supposedly facing our economy. These great investors, who have been successful in analyzing businesses and corporate financial statements, make the mistake of applying their same reasoning directly to the U.S. Federal Government. This type of analysis leads to many errors because of one, crucial, overlooked detail: The finances of the Federal government in no way resemble that of a corporation. It’s like comparing apples to giraffes. Any comparison is illogical, impossible, and nonsensical.
The U.S. Federal Government is a currency issuer, it operates a floating exchange rate nonconvertible currency system, and thus it is monetarily sovereign. The U.S. Federal Government does not borrow money from anyone. The only entity capable of legally creating and issuing dollars is the U.S. Federal Government (for simplicity’s sake, I am combining the Treasury, Federal Reserve, and Federal Government into one entity, since for functional purposes they operate as one entity). The U.S. Federal Government is never in a position of having or not having dollars.
The Federal Government is vastly different from any household, corporation, state government, and even some sovereign foreign governments, such as the European Union nations of Greece and Italy (Greece and Italy are currency users; they cannot issue their own currency.) When the U.S. Federal Government spends, it simply marks up accounts on computers–nothing more. If the amount it spends is more than the tax receipts it has collected, then the government is required to issue Treasury securities in an amount that corresponds to the deficit. Treasury securities represent nothing more than a savings account that pays interest at the Federal Reserve. For a complete overview of the U.S. Monetary System, please see this excellent, in-depth article by Warren Mosler.
Whenever I read the weeping and gnashing of teeth over the current deficit, national debt, and the S&P downgrade, I always see the same thing. The repeated call is that we need to get serious about addressing our unsustainable fiscal policies and reform all the “entitlement” programs. I have yet to read anything that (1) explains what “unsustainable” actually means, that is, why a certain policy will not be able to be sustained; (2) produces any evidence supporting the stated viewpoint; (3) details the specific problems we might encounter later from these so-called “unsustainable” policies (instead of vague threats of unknown future calamities); and (4) gives a specific instance, even one, of how the “high” deficit or debt has personally hurt them or their business (or anyone for that matter). What’s even worse are the Herbert Hoover-ian calls to balance the budget and “cut up the nation’s credit card.”
To understand why we have a deficit and why deficits are important we need to understand why they occur and what role they play in the economy.
In a perfect world, each worker would be able to purchase exactly the amount of goods and services he or she produced with the income he or she received and each worker would spend all of said income purchasing said goods. In a world like this, there would never be a need for the government to run a budget deficit. But the real world doesn’t work like this. There are three main issues that prevent the real world from working perfectly in an economic sense: productivity, the desire to save, and our foreign trade imbalance.
Due to productivity gains, the private sector is able to produce enough goods and services for society without employing all available workers. The Federal Government can fulfill an important role to ensure full employment. This can take the form of the outright hiring of some percentage of the potential workforce to be law enforcement officers, firefighters, teachers, soldiers, etc., or it can take the form of additionally spending to create enough aggregate demand so that the private sector maintains full employment. In either case any spending to maintain full employment should be done above and beyond tax receipts (taxes remove aggregate demand from the private sector).
Many workers (and businesses) desire to save money, and this savings behavior is generally encouraged in our society. There are many valid reasons why society saves (or “hoards” in economic parlance) money. The government provides a very low level of social services. We have no universal healthcare, social security payments in old age are usually insufficient, and we have no universal job guarantees. So saving money for a rainy day is a good idea. In addition, the government provides powerful incentives that encourage workers to save, usually by reducing tax burdens. These incentives include a multitude of tax-advantaged savings mechanisms for retirement, such as IRA accounts, or savings vehicles for various other purposes, such as 529 plans for a child’s college expenses.
The act of saving some of the income you receive rather than spending all of it reduces economic activity. One person’s spending is another person’s income. In order to allow the private sector to save, the government must spend above and beyond its tax receipts (i.e., deficit spend). If the government does not provide the private sector with the necessary funds to save, the result is reduced economic activity and unemployment.
Foreign Trade Imbalance
The final issue that necessitates continued deficit spending is our foreign trade imbalance. The United States imports far more goods than it exports. This is not necessarily a bad thing, since the importation of goods represents real benefits to our economy. The trade deficit means, however, that each incremental good imported beyond an offsetting export produces a corresponding incremental increase of unemployment—unless the government intervenes. Because we import something, the economy no longer has that money to pay a domestic worker to manufacture that item; we paid a foreigner to manufacture it. Deficit spending allows the government to step in and be the provider of aggregate demand of last resort. Its actions promote full employment in our economy.
But What About…
Since the United States Federal Government issues its own currency, it will never be unable to make good on any monetary payment promises it has made. The only question is how much will the currency it issues be worth? That is, will inflation erode the value of the currency? Inflation is the only thing that we have to worry about in our monetary system.
It is important to understand that the very act of “printing money” does not cause inflation. Every dollar in circulation had to be first spent into existence. It is only when these dollars are “printed” and spent in excess that inflation may occur. The key word is “spent.” Unspent money causes no inflation.
It is also important to understand what inflation is and what it isn’t. There are different types of inflation. The two main types of inflation are (1) demand pull and (2) cost push inflation.
Cost push inflation comes from the rise in price of critical goods or services for which there is no alternative. For example, suppose I am the sole producer of LIO, a new substance that is used virtually throughout the economy and for which no close substitute exists. As a