From Strubel Investment Management Q3 letter to investors, which mostly talks about the Federal Government and macro (see Q4 here).

Dear Clients,

The past few months and the upcoming few months look to be rather eventful. The Federal Reserve’s decided to hold off on tapering their Quantitative Easing (QE). We are also now experiencing a federal government shutdown along with threats of failing to raise the debt ceiling because Republicans and Democrats cannot agree on a budget or a path for the economy.

Since the Federal Reserve’s Quantitative Easing basically has little to no effect on the real economy, we will leave that discussion for later.

The federal government’s budget and the debt ceiling have an enormous effect on the real economy, so let’s start with a discussion of that.

Wrong comparisons in washington

The Heritage Foundation (a right-leaning think tank) recently released a report that compares the Federal government to a typical family. The Heritage Foundation is not alone. Obama has frequently compared the budget to a household and has attempted numerous times to reduce the deficit through such things as cuts to Social Security. Here are remarks from Obama’s speech on February 23, 2009, at the Fiscal Responsibility Summit:

And that’s why today I’m pledging to cut the deficit we inherited in half by the end of my first term in office.  This will not be easy.  It will require us to make difficult decisions and face challenges we’ve long neglected.  But I refuse to leave our children with a debt that they cannot repay – and that means taking responsibility right now, in this administration, for getting our spending under control.

Both Democrats and Republicans continue to make the same mistakes and to treat the government budget as if it were a household budget.

On the next column, I have copied one of the graphics from the Heritage Foundation’s report titled “What if a Typical Family Spent Money Like the Federal Government?”

While it is an attractive graphic and is full of important sounding numbers, it is as useful as if I mailed you (my clients) a quarterly letter titled “How Ben Would Manage Your Money if He Were an Orangutan.” It might be an interesting report, but it isn’t full of any useful information. The federal government isn’t a household, and I’m not an orangutan.

federal-government

Let’s look at each element of the government-to-household comparison one by one.

Household and government income and spending

Household income and the money the government collects in taxes are very different. For a household, one or more individuals go to work for an organization and receive a set amount in wages in return for their labor.

The government simply collects money via taxation. The government has the power to collect as much (or as little) money in taxes as it wants. When the government collects taxes, this removes demand from the economy. If I have $100 and the government takes $10 via a tax, then I only have $90 that I can spend.

Conversely, when the government reduces taxes it adds demand. In the previous example, I had $100 and the government taxed away $10. Instead, if it taxed away only $5, then that would leave me $95, or an extra $5, to spend.

Also, when the government spends money, it adds demand to the economy. If the government decides to build a new school and hires construction workers to build it and teachers to staff it, it is adding demand. When the government spends less money, it is taking demand away from the economy. When the government lays off workers or stops building bridges, the economy slows down.

Government spending acts like the thermostat of a house. If the economy is cold and unemployment is high, then turning up the thermostat and spending more money or lowering taxes will heat up the economy.

If the economy is roaring along and unemployment is nonexistent and inflation is high, then raising taxes or reducing spending can help the economy cool down.

Comparing the government to a household makes no sense. What kind of household is able to adjust its income at will? Imagine walking up to your boss one day and just announcing you are giving yourself a 10% raise!

The Federal government doesn’t have a credit card

In the household example from the Heritage Foundation, they show the household putting the difference between its income and spending on a credit card. You frequently hear politicians from both sides of the aisle use the same analogy.

At first glance it makes sense. Part of my job is helping clients manage finances and that includes making sure they don’t spend more money than they earn. Despite sounding logical on the surface, the analogy to the government is wrong.

When the federal government spends more money than it collects in taxes, it runs a deficit. What exactly does this mean and how does it affect the economy?

There is only one entity that can legally issue US currency. That is the federal government. Every single dollar in existence (legally) was created by the federal government.

Right now, the government has an infinite amount of potential money. If they brought in an extra $100 in taxes, then they would have infinity plus $100, which is infinity. If they brought in an extra $100B in taxes, then they would still have infinity.  In the same vein if the government spent an extra $100B, then they would still have infinity dollars left. So that is the first difference between the government and households. The government is never in a state of having or not having money. It always has infinity dollars. The question is how it should spend and tax and what should be taxed and what the money should be spent on.

When the government spends more money than it brings in, it issues treasury bonds (or bills or notes). The popular misconception is that the government must first sell the bonds so that it can get the money to spend. This is false.

What actually happens is that the government spends the money first and then issues treasuries second in order to support interest rates and ensure the banking system functions smoothly and that interest rates do not fall to zero.

A household has a limited supply of dollars. When they want to spend more they need to borrow the difference from someone that does have dollars. The federal government can simply create extra dollars at will via deficit spending. If the economy is sluggish and unemployment is high the government needs to pump more money in to the economy.

We shouldn’t be arguing over whether or not the economy needs more money (it does) we should be arguing over the best way to get that money in to the economy.

Federal Government versus household debt

When we talk about debt, we take it to mean money that we owe someone that we will need to eventually pay back in full. We also usually think of debt as something negative. Being in debt is thought of as bad and being debt free is good. For a household that is generally true.

But one person’s debt is also another person’s income. For instance, I am currently in the midst

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