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George H. Blackford, Ph.D.

 Economist at Large

 Email: george(at)rwEconomics.com

 

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A Note on Managing the Federal Budget 

George H. Blackford, 2014

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There is a fundamental difference between federal debt and non-federal debt that arises from the fact that the federal government has the legal right to print money. This means there is no reason to believe the federal government will ever be unable to service its debt because it can always just print the money it needs if it has to. Non-federal debtors cannot print money. They must service their debts out of income or through the sale of assets and, as a result, are always at risk of being unable to meet their financial obligations.

The fact that the federal government has the power to print money does not mean we do not have to worry about federal debt or that ďdeficits donít matterĒ as was the mantra of the Bush II administration. It matters a lot just how those deficits are created and how they are financed, but the fact that the federal government has the power to print money means that the federal debt problem is a much easier problem to deal with than the non-federal debt problem. It also means that the federal government has the power to mitigate the overall debt problem we face through the judicious management of its budget in a way that non-federal debtors do not.

When the federal government borrows and uses the proceeds to finance an increase in expenditures for goods and services in the face of an economic downturn it increases spending in the economy directly and thereby directly increases the demand for goods and services.

The same is true when the government borrows in this situation to increase transfer payments (such as increased payments for agricultural subsidies, unemployment compensation, or aid to municipalities) or to finance tax cuts that created the need to borrow in the first place, though here the effect on the demands for goods and services is less certain in that these effects are indirect. They can have an effect on the demands for goods and services only to the extent that those who received the transfer payments or tax cuts increase their spending on newly produced goods and services as a result. There is, of course, no guarantee this will occur.

Deficits that occur during an economic downturn that help to maintain or increase expenditures on education, scientific research, public health systems, police and fire protection, water and sanitary treatment facilities, bridges, highways, and other forms of public transportation all have the direct effect of stimulating the economy. Even expenditures that arise from increases in the kinds of transfer payments embodied in food stamps, unemployment compensation, school lunch programs, Medicaid, and other kinds of social welfare programs that tend to increase during an economic downturn help to stimulate the economy since most of these transfers go to people who live hand to mouth, and, therefore, are more or less forced to spend.  

In addition, most, if not all of these kinds of expenditures, whether direct expenditures or social welfare transfers, have the added benefit of making it possible to improve productivity in the future by improving our public infrastructure and warding off the malnutrition and other health problems that are the inevitable consequence of people becoming destitute in the wake of an economic downturn. Thus, running a deficit to finance these kinds of expenditures and transfer payments during an economic downturn adds stability to the system and has the potential to help the economy grow and, thereby, to reduce the burden of servicing the debt that deficits create.

By the same token, deficits that occur during prosperous times or that are created in the midst of an economic downturn by giving tax cuts and increasing transfer payments to the ultra wealthy who, in turn, use the proceeds to buy the bonds needed to finance the deficits created by the transfers and tax cuts in the first place do not stimulate the economy and do not have the added benefit of having the potential to improve productivity in the future. They simply increase the transfer burden from debtors (i.e., taxpayers) to creditors as they distort the allocation of resources within the system with a dead loss to the society as a whole. In addition, this kind of fiscal irresponsibility on the part of the government has the potential to create chaos within the economic system.

Even though there is no default risk to federal debt, when federal debt grows faster than the GDP it increases the burden of transfers from debtors to creditors which can lead to serious problems, especially if the debt is foreign owned. In addition, there is a huge risk of inflation as the federal debt grows if it reaches the point where the government cannot raise the money to service its debt through taxes or borrowing and is forced to print money. The resulting inflation can have the effect of increasing interest rates and, thereby, making the transfer problem worse as it weakens our position in international markets. If severe enough, hyperinflation can lead to a total collapse of the monetary system as creditors refuse to enter into contracts of any sort that are written in terms of the domestic currency.

Thus, the ability of the federal government to print money is not a blank check that allows the federal government to do whatever it chooses. It only gives the federal government a degree of flexibility in managing its affairs that no other entity within the economic system has, but the federal budget must be managed responsibly if catastrophe is to be avoided. This does not mean that the budget should always be balanced or that federal debt should be paid off as quickly as possible. Attempting to do so can have disastrous consequences.

What it does mean, however, is that during an economic downturn the deficit and debt must be increased in such a way as to maximize the economic stimulus while, at the same time, alleviating human misery and building up our public infrastructure as much as possible in order to minimize the economic decline and increase our ability to produce in the future. It also means eliminating unproductive or wasteful programs and expenditures during prosperous times. But most important, it means raising the taxes necessary to pay for the government programs and expenditures that are essential to our economic and social wellbeing when the system is at its full potential and in such a way as to eliminate the imbalances in the system.

As I try to explain in Ch. 12: Less Government, Lower Taxes, and Deregulation, not managing the budget in this way and, in particular, not raising the taxes necessary to pay for the government programs and expenditures that are essential to our economic and social wellbeing and not eliminating the imbalances in the system is courting disaster. (Stiglitz Klein Johnson Crotty Bhagwati Philips Galbraith Morris Reinhart Kindleberger Smith Eichengreen Rodrik Krugman Amy

 

 

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