Time To Review Federal Deficit Myths

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Time To Review Federal Deficit Myths by Ben Strubel, Strubel Investment Management

Dear Investors,

The main election season is almost upon us with the race narrowed down to Donald Trump versus either Hillary Clinton or Bernie Sanders, with Clinton being the likely nominee. As the race is heating up, we are hearing more and more dumb things about the national debt. So, once again, I’ll bust some of the myths surrounding the debt and federal deficit.

Do You Want to Deprive My Grandma?

Let’s start by talking about my grandma Grace. She owns some Treasury bonds. Remember, the national debt is simply all outstanding Treasury bonds. If we wanted to pay down the national debt, we’d have to take away Grace’s Treasury bonds and my poor grandma would have less than she did before. So, if you think paying down the national debt is a great idea, you need to explain why you think making Ben’s poor old grandma poorer will help the country. In addition, many of you, my clients, own some Treasury bonds too. So, why would you want to be poorer as well?

We’ve all had it beat into our heads that the national debt is bad. Politicians say it, rich hedge fund managers say, corporate executives say it, the media says it, confused economists say it, and on and on. So when you hear me say the national debt isn’t bad, you might think I sound kind of crazy. That’s why I told you about my grandma. Even if you don’t quite believe me, at least the example of my grandma should make you rethink everything you’ve heard about the debt. I hope my example makes you think that, just maybe, there’s an alternate explanation about the national debt.

Federal Deficit – Take a Closer Look

Let’s take a closer look at how the debt and the federal deficit work. Imagine the government wants to build a highway. The highway is going to cost $100M dollars. So, the government taxes its citizens exactly $100M. The government uses the money to hire workers, lease equipment, buy materials, and build the road. The $100M is put back into the economy. The workers spend their wages on new cars, TVs, mortgages payments, dining out, and more. The construction company spends its profits by upgrading equipment. And so on.

Some workers at the construction companies are close to retirement, so they decide to save most of their paychecks. The owner of one construction company remembers how bad things got back in 2008. Better hold off on buying those new dump trucks and that new excavator, he thinks, and decides to save his profits. What happens because of those savers? The economy shrinks. The government took out $100M in taxes from the economy. The government then put all $100M back into the economy through the new highway construction project. But some people saved that money, so only about, say, $95M went back into the economy because $5M was saved. This example is pretty close to what a balanced budget is like. The government spends only what it takes in through taxes, but because the private sector wants to save some of its money the economy shrinks.

It’s even worse if you try to pay down the debt. Imagine if the government raised taxes and took in $110M and only spent $100M on a new road with $10M going to pay down the debt. The private sector would be even worse off. You’d have the private sector trying to save $5M plus an extra $10M gone in taxes. The hole in the economy would grow to $15M.

What should be done? Say the government takes in $95M in taxes and builds the same $100M road. The private sector has the extra $5M in savings they desire ($95M taken out, $100M back in, $5M saved, and $95M spent = the same $95M taken out). The economy would be at equilibrium.

The difference between government spending and government tax revenue is the federal deficit. You almost always need to have a deficit because the private sector desires to save. Over time, the cumulative federal deficit equals the national debt.

Now, of course, this is a very simplistic example. Some of you are probably screaming, “Ben, what about …..?!”

Interest Rates

Interest rates are set by the Federal Reserve not the bond market. It’s that simple. In fact, if it weren’t for the Federal Reserve, interest rates would actually fall to zero. The amount of debt outstanding has nothing to do with the interest rate and the bond market can only influence the interest rate if the Federal Reserve allows it too. Japan has a national debt that exceeds 200% of GDP yet some of its government bonds have negative yields. Why? Well the Bank of Japan (the Japanese Federal Reserve) set interest rates to less than zero.


Now inflation can be a legitimate concern. Inflation is the only real constraint a currency issuer has on spending. If every single person who is willing and able to work is employed and all of the country’s industrial capacity is used up, then deficit spending above and beyond what is necessary to fulfill the private sector’s savings desires will result in broad based inflation (rising wages, rising prices, etc.). If there is still a large stock of unemployed people and unused industrial capacity, then increased spending will simply be absorbed by the economy. This is what happened when had record deficits in 2009 and 2010 yet broad based inflation was virtually nonexistent. As the economy grows, new jobs will be created and the unemployed will come back to work and old factories will reopen.

Savings and Investment

For some bizarre reason, economics professionals, in particular the academics, believe that banks lend out savings. That is, in order for a bank to loan money to businesses to expand, they banks first need customers who deposit their money at the bank. That just isn’t how banks work. That’s why when you get a mortgage or a car loan, you never hear the loan officer say the bank is out of money or they’ll check around to see which banks have money to lend. The Bank of England and the Federal Reserve have all explicitly stated that banks don’t loan out savings. Banks create loans out of thin air. If you borrow $100,000, then the bank creates a $100,000 liability, which is your deposit (i.e., the bank owes you $100,000) and a $100,000 asset, which is your loan (i.e., you owe the bank $100,000 for your mortgage now). It’s just truly strange that most of the mainstream academic world refuses to accept the reality of how bank loans work and incorporate it into their economic models.

Big Gub’ment

Not all of us like government. In fact, I’d being willing to bet we all have different opinions on what the “best” role of government is and just how big and involved it should be. A lot of what I’m saying may sound like more big government talk. Not so. In my example above, I used the construction of a new highway, which would be an expansion of government. If that’s not in line with your beliefs, that’s fine. I am not advocating for the government to build more roads; I merely used that as an example to explain the economy. The economic model works regardless of the example you use. Just substitute whatever you want. It could be lower taxes, more education spending, a new aircraft carrier, more social spending, a $1000 check written out to every citizen, or a combination of all of those. As long as the spending versus taxation math works and the federal deficit is large enough to support growth, the economy should be fine.

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