Deficit Myths

There are two prevalent myths about government deficits.

1. (Myth 1.) Government deficits accumulate to government debt, which must be paid back in higher taxes.
2. (Myth 2.) Government deficits are not stimulus, because increasing the money supply (which is what a net government deficit does) will just increase prices, if no taxes are raised, so the purchasing power of the extra dollars lowers to adjust to the status quo, and the net effect is just a temporary disruption in the market.

Myths can be true of course, but these are both false.

Myth 1 is true in the first part, yes, government deficits accumulate into government debt. The myth is that has has to be repaid. But there is a second sub-myth associated with this one, which is about the tax return that “pays for” the rising government deficit.

Myth 2 is the Ricardian Equivalence fallacy. It is a false myth because it implicitly uses the QTM myth, that increasing money supply causes price inflation. We already debunked this in the chapter on inflation, but below we can add a few more nuances.

Let’s look at these in more detail.

The Myths about the Deficit pay-back

Government deficits accumulate to government debt — true

Government debt however, is held in the form of each of these money forms:

• cash in wallets,
• bank deposits,
• Treasury bonds.

Treasury bonds are functionally like government guaranteed bank term deposits, they promise interest payments. Cash and bank deposits that are not being spent are demand leakages, so are not causing inflation, and thus not causing any higher tax return.

The government does not need to take back this cash and those bank deposits. The government has already issued the money that was used to buy bonds (it was formerly cash or bank deposit, swapped now for an interest bearing Treasury security).

Most people think of “national debt” as only the Treasury bonds — why? Because these are the only forms of government deficit that the government promises to pay interest on, so is an “obligation” over and above the obligation to merely accept the currency back as payment (redemption) for tax liabilities.

Rising government debt means higher tax return — true

For most economies, when the government debt rises there is more currency, but it is not always being spent. But let’s suppose it is being spent (so not all held as bonds). Then the increase financial activity in the government’s tax credits will automatically increase tax return.

But this is automatic, no new extra taxes are needed. Sales tax and FIA tax for example is sufficient. But those are regressive taxes. Suppose there was just a flat land tax per acre of unoccupied land, or per cubic metre of occupied real estate.

There is no “burden” on the government in accepting back their own currency for payment of these taxes. They always redeem! Why would they not?

The burden is on the non-government sector. But this is a good thing. The myth is that this is a bad thing.

If the economy is booming the non-government sector is dong well, and any poverty and unemployment is dealt with by distribution policies, not monetary or tax policy. So the increased automatic tax return has the function of automatically helping stabilize prices, this is a good thing, not a bad thing.

This Warren Mosler’s Seventh of the Seven Deadly Innocent Frauds of Economic Policy :

No. 7: “Rising Government debt today means higher tax return tomorrow.” This is true. The myth is that it is a bad thing.

Myths about the deficit not being stimulus

I already gave the one-liner on Ricardian Equivalence. It’s a false myth.

The idea is that government deficits are “not stimulus,” because increasing the money supply (which is what a net government deficit does) will just increase prices, if no taxes are raised, so the purchasing power of the extra dollars lowers to adjust to the status quo, and the net effect is just a temporary disruption in the market. That’s the idea of Ricardian Equivalence. It is a false idea.

The popular economics reasoning behind Ricardian Equivalence is a deification of the average person with market power (someone who has a lot of currency): which is that they take a look at the government deficit, and factor this into their consumption choices: to hold on to cash or to spend.

The mythical idea is that such rational people we all are, and that we go on a short spending spree, but then defer our consumption if we see a rising government deficit because we think this will inflate prices soon, so we wait until we starve or deplete what we got from our spree before making our consumption in the future once inflation comes down — or something like this. (Interest rates also will play a minor role in this, to the extent the interest rate is the penalty for holding cash rather than bonds or spending it.)

Total bullsh*t of course. No one thinks and acts this way except a neoclassical economist, and even then, only in their dreams.

The reality is that prices are determined by relative value stories, and so,

1. government deficits targeted to move production from wasteful sectors to productive sectors violate Ricardian Equivalence, meaning they are direct stimulus.
2. Other demand leakages (savings) can be insatiable, and they obviate the need for tax return to stabilize prices, so provided there are people with insatiable desires to save, Ricardian Equivalence is again violated, and government net spending can be a great stimulus, if spent wisely on real production.

Having stated these points the burden of proof is on economists who still think Ricardian Equivalence is effective. For any given country it might be the case Ricardian Equivalence will apply, but that will only be the case if their economy is at full employment, or has reached some other bottleneck.

if you do not like this theoretical reasoning, then I urge you to take a look at any reasonably healthy economy during war time. Their governments always increase the government deficit, and it is a massive stimulus.

The “cost” of this is a shift of production from say farm implements to missiles, guns and ammo. But it is still a stimulus, and can be empirically checked.

The tax “pay for” is automatic, as per Mosler’s 7th of the Seven Deadly Frauds. Governments get the war time stimulus needed without needing to raise taxes, provided the existing tax rate is progressive.

In major wars, like WW-2, governments typically have to do a bit more than rely on automatic stabilising tax return, they typically need to withdraw demand from the sectors that the war effort is borrowing real resources from, such as labour, non-war machinery production (automobiles, and other equipment) and oil. The point is not to deprive the economy of those goods, but rather to shift them away from private sector production into the war effort production.

You do not have to agree that this is a god type of stimulus! That all depends on the reason and cause and justification for the war effort (usually there is no moral justification, unless it is purely defensive).

Yet everything just said can also apply to non-war effort, like greening the energy sector of the economy or providing free healthcare and education. The perennial war on ignorance. Governments almost always out-bid the private sector for hiring of teachers, but not well-enough, there are still plenty of useful teachers who remain under-employed (which can mean simply under-paid).

The governments withdraw this demand with a mix of polices, some fees, a lot of war bonds, and a lot of rationing, and some price fixing along with subsidies. So there is a weak Ricardian effect here, but it is not anything any rational agent can foresee, since no one knows when a war will end.

(It is debatable whether modern neoliberal governments understand any of this, they probably do not, so if they get into a major war they’ll probably cause hyper-inflation, until the war stops. MMT tells them they do not need to tolerate hyperinflation during a pandemic or a war, but will they listen? Probably not, they’re ideologues who do not respect the reality of monetary systems.)

Keynes knew this already before MMT

In the letter to FDR, Keynes put it fairly plainly:

Broadly speaking, therefore, an increase of output cannot occur unless by the operation of one or other of three factors. (1) Individuals must be induced to spend more out of their existing incomes; or (2) the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees, which is what happens when either the working or the fixed capital of the country is being increased; or (3) public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money. In bad times the first factor cannot be expected to work on a sufficient scale. The second factor will come in as the second wave of attack on the slump after the tide has been turned by the expenditures of public authority. It is, therefore, only from the third factor that we can expect the initial major impulse.

Euro economist Dirk Ehnts put it like this:

A bit further down the text Keynes says that monetary policy should aim at “maintenance of cheap and abundant credit and in particular the reduction of the long-term rates of interest.” Clearly Keynes thinks about combinations of interest rates and levels of government spending that lead to full employment, but it is government spending that is of utmost importance.

Another way to put this is that government net spending provides the collateral whereby firms in the macro can be confident bank credit they use for investment can be paid back by households without a private sector debt-deflation collapse.

Or, a growing economy needs a growing net money supply.