The private sector can generate wealth all on its own--it doesn't need the government for that. That is the myth that government operates under, though--witness the recent stimulus programs, none of which can be economically justified or achieved their indicated result.
Of course private sector can generate goods and services on its own. I haven't claimed otherwise. However, currency is not wealth but is rather and accounting of wealth. It is the score of wealth , not the wealth itself.
Let me ask a very simple question: If deficits are so good, then why, with our constant stream of deficits, don't we have an increasing governmental revenue stream which makes deficits unnecessary?
Let me answer this question with a question of my own and if you feel it doesn't clarify enough I'll try to expand further. What would happen if the government, in an attempt to pay off the national debt, instituted a 100% tax on all privately owned assets?
Through loans from banks. What does the Fed EVER spend anything on? It's not a spending entity.
So congress does not enact spending programs? Where did the stimulus come from? Scott Pelley of 60 Minutes asked Bernanke this specific question in March of 2009. The question and repsonse is transcribed
PELLEY: Is that tax money that the Fed is spending?
BERNANKE: It's not tax money. the banks have-- accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed. so it's much more akin to printing money than it is to borrowing.
I'm not stating the deficit itself is all bad--I'm stating that HUGE deficits lead to economic problems. Eventually, an enending stream of even modest deficits will cause problems too. It's unavoidable. Again, consider interest rates. They are artificially low right now, and even with those, we have a $700 billion structural deficit. Interest rates WILL return to normal, and probably even higher, and this will add about another trillion dollars to that.
Hobbes, what is the natural rate of interest? I'm assuming since you believe that they are "artificially" low right now that you have an idea of what the natural rate should be. Additionally, reality does not support your thesis. For example, the 30 year treasury as of today it sits at 3.875%. Historically the 30 year was 13.45% in 1981 and has been decreasing ever since. Unless my data is incorrect, the national debt has increased from about $900 Billion in 1980 to over $13 trillion in 2010. But how could this be? How do long term rates decline while the deficit increases? Have rates been held "artificially" low for the last 30 years? Shouldn't the market be punishing the US for our fiscal recklessness by now? It seems that the market has given the US a vote of confidence in complete contradiction to prevailing wisdom on deficits. Odd isn't it? additionally, japan has one of the highest debt to GDP ratios of any developed country on the face of the earth. debt was 170.4% of GDP according to Visual Economics website
. A look at Bloomberg
today shows me that the 30 year japanese bond is currently 2.00%. Is Japan an exception to the rule as well? I'm honestly not trying to be snarky or sarcastic. I'm just frustrated that the conventional economic wisdom has been dead wrong since nixon took us off the gold standard. The forecasts of high rates and increasing inflation that were predicted have been dead wrong. Rates and inflation have done precisely the opposite of what many conventional economists thought would happen. At some point, if the theories consistently produce incorrect predictions, the theories must be questioned. If every economic forecast must be revised due to "artificial" situations or exceptions to the rule, then what good are the rules in the first place?
I'm not concernecd with what our inflation rate is, I'm concerned with what it will be. The situation we have would be akin to telling someone on the beach a tidal wave is coming, and having him reply that the water is fine right now. Our inflation rate is low because our economy is weak, and demand is limited. Hardly the go forward position we'd want to maintain, right?
Actually your concerned with what it MIGHT be if we do not control inflation once aggregate demand is restored. Once again, inflation is well understood and is an economic condition that the fed is well equipped to deal with.
[Regarding the similarity between Greece and the US] Absolutely we are. Look at all the metrics used to indicate how bad their governmental finances were, and we are on par on all of them.
The metrics are not comparable as Greece is part of a monetary union and is thus not a sovereign issuer of their own currency whereas the US is. Do you truly not understand that greece is effectively a user of the euro and not an issuer? Can Greece inflate their way out of their debt even if they wanted to? Could Greece allow the euro to depreciate until foreign trade begins to pick up some of their demand? Of course the answers to both questions are no because Greece isn't the only country that uses the Euro. Do you think Germany and Greece share the same desires for the strength of the Euro? Of course not. Joining the european currency has forced the fiscal policies of the member nations into a "beggar thy neighbor" approach.
That's why the bonds are issued, because the government doesn't have the money. If the funds were there...why do they need to keep issuing bonds?
Incorrect. Bond proceeds fund nothing but rather serve as a reserve drain and allow the fed to maintain control over short term rates. Let me explain.
As you know, banks have to maintain a reserve ratio that is set by the Fed. The reserve ratio limits the amount of deposits that that the bank can lend. For example, if the reserve ratio is set at 10% the banks must maintain 10% of all (not actually all deposits but I’m simplifying for understandability) their deposits on hand. So, for example, a bank has $100 dollars in deposits. If the reserve ratio is 10% the bank must maintain 10% of $100 or $10 in reserves and can lend out $90.
Because deposit and loan levels are changing from day-to-day and minute-to-minute, the calculation of the amount that a bank needs to legally hold for a reserve is a moving target. In effect, the government solved this problem by allowing banks to calculate their reserve requirement based upon a date that had already passed. For example, the bank would calculate the amount of deposits it had on Monday’s date and that would be the reserve requirement for Wednesday. This effectively creates a two day lag as the bank knows two days in advance what the legal reserve requirement should be.
In reality, banks don’t pay much attention to the legal reserve requirement when making loans as banks know they can borrow the money to increase their reserve position should they lend out too much or should deposit levels drop precipitously. As long as the interest rate the bank charges on loans is higher than the rate they have to pay when borrowing money, it makes sense to make every loan that they can. In effect, bank lending decisions are affected by the price of reserves, not by reserve positions. If the spread between the rate of return a bank can get from making a loan and the interbank rate is wide enough, even a bank deficient in reserves will make the loan and cover the cash needed by purchasing (borrowing) money in the funds market. This fact is clearly demonstrated by many large banks when they consistently purchase (borrow) more money than their entire level of required reserves.
So where does the money that banks borrow come from? The first place they can get the money from is other banks that have excess deposits but not enough loans. Going back to our first example, if a bank has $100 in deposits it can legally lend $90 of the money assuming a 10% reserve requirement. If it lends anything less than $90 it will have excess reserves. Banks don’t like to have excess reserves as the excess money does not earn anything for the bank. So instead of letting the excess reserve do nothing, banks will lend these funds to other banks who need cash to meet their legal reserve requirement. The rate that banks charge each other on these loans is strangely called the Fed Funds Rate but it's less confusing to think of this as the interbank rate. When you think logically about this rate you will soon realize that if the banking system as a whole does not have enough reserves to meet legal requirements than, regardless of how the reserves are divvied up via interbank loans, at least one bank will fail to meet the reserve requirement. Given this reality, the interbank loan rate would be bid up to infinity as the banks who don’t hold enough reserves bid against each other to attract money from the banks who have excess reserves knowing that at least one bank will be left short. The opposite is also true. If there are excess reserves in the banking system as a whole the rate offered will be pushed to zero as the banks with excess reserves will continue to offer their excess reserves at lower and lower rates in an effort to make even the smallest return on their excess reserves (which would otherwise earn 0%).
Now, with a rudimentary understanding of how bank reserves work we can begin to talk about Bonds. If the government spends money by buying hammers from the private sector, than the account of the company who made those hammers will increase by the price of the hammers. This also means that the bank that holds that company’s account now has more reserves as its deposit balances have increased. If, through a combination of high government spending, high savings rates (increases deposits and thus reserves) and/or low loan demand, the banking system ends up with reserves in excess of required reserves we now know that the interbank rate will be driven to zero. In order for the Fed to be able to spend AND maintain control over the short term interest rate the fed will need to drain the excess reserves to maintain the funds rate above zero. They do this by draining the liquidity (excess reserves) from the system via sales of T-bills. The sale of t-bills gives the bank a place to park excess reserves and sets a minimum rate for interbank loans. If a bank holds excess reserves the lowest rate that it will be willing to accept if it lends the excess to another bank is the rate that the government will pay on a T-Bill as the bank knows that if it doesn’t lend the funds to another bank in the interbank market it can just place those funds with the government and earn the T-Bill rate.
Voila, the Fed now has the ability to spend any amount without having to worry about the banks having excess reserves and thus driving the interbank rate to zero. The government can now spend any amount while still maintaining a positive overnight lending rate (known as the target rate). So, if the government wants to lower liquidity (reserves) it can either increase taxes (thus lowering bank reserves) or it can sell T-bills. If it wants to add liquidity to the system it can spend (run a deficit) or buy T-bills from the private sector (thus giving the private sector money in exchange for their existing T-bill savings). The mechanism works both ways.
I know this is a long post and I hope you stuck with me through this as I've attempted to make it as simple and understable as possible. To summarize, if the central bank (the fed in the US) has a positive target for the overnight lending rate, it formerly needed to provide an interest-bearing alternative to, what were then, non-interest-bearing bank reserve accounts. This was typically done by offering securities for sale in the open market to drain the excess reserves. Central Bank officials and traders recognize this as "offsetting operating factors" since the sales are intended to offset the impact of fiscal policy that would cause the Fed funds rate to move away from the Fed’s target rate. In nations like the US, Japan, and others, where interest was not paid directly on central bank reserves, the penalty for deficit spending and not issuing securities was not (apart from various self-imposed constraints) bounced government checks but a zero percent interbank rate, as is the case in Japan today. The overnight lending rate is the most important benchmark interest rate for many other important rates, including banks’ prime rates, mortgage rates, and consumer loan rates, and therefore the interbank rate (known as the Fed Funds rate) serves as the base rate of interest in the economy.
It is also interesting to note that the fed began paying interest on reserves in 2008 thus bonds don't even effectively serve the purpose of establishing an overnight rate anymore as the interest rate on reserves accomplishes the same thing.
I know this all sounds heretical but it is completely and 100% operationally consistent with how our monetary system functions. Are you open minded enough to at least consider that what you think you know may be inaccurate? If you are, check out the following PDF from Warren Mosler. The Seven Deadly Innocent Frauds of Economic Policy
. It's a long read but a very important one.
Thanks for the interesting discussion Hobbes. I appreciate the lively interaction.