Dan here…a reminder about our federal deficit.

Deficits Do Matter, But Not the Way You Think
07.20.10    Roosevelt institute  L. Randall Wray

In recent months, a form of mass hysteria has swept the country as fear of “unsustainable” budget deficits replaced the earlier concern about the financial crisis, job loss, and collapsing home prices. What is most troubling is that this shift in focus comes even as the government’s stimulus package winds down and as its temporary hires for the census are let go. Worse, the economy is still — likely — years away from a full recovery. To be sure, at least some of the hysteria has been manufactured by Pete Peterson’s well-funded public relations campaign, fronted by President Obama’s National Commission on Fiscal Responsibility and Reform — a group that supposedly draws members from across the political spectrum, yet are all committed to the belief that the current fiscal stance puts the nation on a path to ruinous indebtedness. But even deficit doves like Paul Krugman, who favor more stimulus now, are fretting about “structural deficits” in the future. They insist that even if we do not need to balance the budget today, we will have to get the “fiscal house” in order when the economy recovers.

In fact, MMT-ers NEVER have said any such thing. Our claim is that a sovereign government cannot be forced into involuntary default. We have never claimed that sovereign currencies are free from inflation. We have never claimed that currencies on a floating exchange rate regime are free from exchange rate fluctuations. Indeed, we have always said that if government tries to increase its spending beyond full employment, this can be inflationary; we have also discussed ways in which government can cause inflation even before full employment. We have always advocated floating exchange rates — in which exchange rates will, well, “float”. While we have rejected any simple relation between budget deficits and exchange rate depreciation, we have admitted that currency depreciation is a possible outcome of using government policy to stimulate the economy.

A favorite scenario used by the critics is the ever-rising budget deficit that causes the government debt-to-GDP ratio to rise continuously. As interest payments on the debt increase, government faces a vicious cycle of rising deficits, more debt, more interest paid, higher interest rates, and even higher deficits.

Our response is two pronged.

First, OK, let us accept your premise. Will the government be able to make all payments (including interest paid on debt) as they come due? The answer is, of course, “yes — by crediting bank accounts”. Insolvency is not possible when one spends by a simple keystroke. The critic then quickly changes the subject: Weimar! Zimbabwe! You are a destroyer of the currency! Yes, but it was your scenario, not mine. And even in your worst case scenario, the government cannot be forced to default. Instead, Krugman argues “the government would decide that default was a better option than hyperinflation”. In other words, Krugman veers off into politics — government “decides” to default — because the economics does not give him the result he wants.

Second. Your scenario is highly implausible. As budget deficits rise, this increases income (government spending exceeds tax revenue, thus adds net income to the nongovernment sector) and wealth (nongovernment savings accumulated in the form of government debt) of the nongovernment sector. Eventually, this causes private spending and production to grow. As the economy heats up, tax revenue begins to grow faster than government spending or GDP. (In the US over the past two cycles, in the expansion phase federal tax revenue grew two to three times faster than GDP and government spending.) This reduces the government deficit (remember the Clinton boom and budget surpluses?). Even if the government spending is on interest (in Krugman’s model, the deficit is due to interest payments) that generates nongovernment income and spending. In other words, the cyclical upswing will automatically reduce the budget deficit. The scenario ignores the “automatic stabilizers” that cause the budget deficit to swing counter-cyclically.