I'm pleasantly surprised by this column at MarketWatch. Actually more like gobsmacked. I realize the post's title is a wee bit obscure, so some background is order. One of the reasons I write about budget deficit hysteria all the time is that the belief that WE MUST REDUCE TEH DEFICITZ! NAO! is used by the forces of evil to cut important things...like science funding (a few people 'round these parts might care about that). And Pell Grants. And heating for poor old people. And food for poor children. And... Well, you get the idea. Mysteriously, deficits never seem to be a problem when when tax cuts for the rich are discussed. But I digress.
One of the key innovations of the last century--and unappreciated, not to mention unknown, by most--is fiat currency: we are not on the gold standard anymore. The total amount of money we can have isn't fixed by how many shiny pebbles we can pull out of the ground. If we need to print more money so we eliminate idle capacity (human and industrial), we can simply do that. Inflation can arise once we eliminate that idle capacity. Likewise, if we flood a sector (or economic class) with money, that can lead to inflation in that sector as well as misallocation of resources. As much as I would like it, pumping $250 billion per year into microbial genomics probably wouldn't be a good idea. But arbitrary concerns about deficits shouldn't limit our economic activity.
The other key point is that the budget deficit (the amount spent by the government beyond what it collects in taxes and other revenues) is simply the result of the trade deficit and private savings. That is, even with no trade deficit, if the private sector has net savings (across all private entities--some people will obviously owe money to others), then the government must run a deficit. The trade deficit can simply be thought of as privately held savings external to the U.S. (we give them dollars, and they give us stuff). This isn't liberal ideology, this is how the world works every day.
If we rub these two points together, what this means is that deficit increases or reductions don't matter per se, it's how we reduce or increase the deficit that matters. Throwing people out of work and having idle capacity by cutting back on spending? Could be stupid, depending on the spending. Increasing or decreasing taxes? Depending on the outcomes (e.g., how does this affect income equality or reduce the incentive for certain behaviors), it can be good or bad.
Which brings us to the MarketWatch column:
"Fiscal nightmare," "buried under a mountain of debt," "awash in red ink" - these are some of the colorful phrases being bandied about by politicians, pundits and even journalists ostensibly reporting facts. Most of them are winging it on a single undergraduate course in economics, if that, but they know they're right because everybody agrees.
Yet, if you look out the window, you don't see any red ink or mountains of debt. The only nightmare is unemployment continuing near 10% and ongoing waves of foreclosures - neither of which is attributable to the federal deficit and neither of which will be fixed by budget cuts.
There is cause for alarm. There is the possibility that the government, held under the sway of misguided and obsolete economic theories and driven by a not-so-hidden corporate agenda, will make genuinely harmful cuts in both discretionary spending and entitlement programs - cuts that will cause real and needless misery to millions....
But the helter-skelter axing of programs to meet a target pulled out of thin air - what's so magic about $100 billion in spending cuts this year? - risks causing much unnecessary harm.
Dont read that often in business-oriented publications. Back to the column (italics mine):
When the U.S. was bound by the gold standard, it also faced constraints. Most of the thinking and language about budgets and deficits actually goes back to this time, when the U.S. genuinely had to "finance" its deficit.
Since abandonment of the gold standard and the de facto adoption of a fiat currency, however, these constraints no longer apply. The U.S. is free to print as much money as it likes; the U.S. government is free to spend money without financing it.
How crazy, you say. What about inflation? Inflation occurs when there is more demand than supply and this simply isn't going to happen when there is 8-10% unemployment. Treasury and the Fed have ample tools - selling debt securities and raising interest rates - to deal with inflation when it does threaten.
Modern monetary theory - which is espoused by a growing number of economists and investment managers because it explains the observable facts better than the obsolete theories driving most of the public discussion - deals with the world as it is without a gold standard....
The federal government is also not comparable to a household. It does not have a checkbook to balance or a credit card to max out, even though our folksy politicians like to use these metaphors. It does not have to "live within its means" like a family or individual. Our grandchildren will never have to repay all that debt. No one will, ever. It will continue to grow as our economy grows.
All this flies in the face of all the groupthink going on in Congress, in the press and on cable TV. So if you want to reject modern monetary theory as hogwash and cling to theories that worked a century ago, you're in good company. But think about it, look around you, and decide for yourself what best describes the world you live in.
This is not The Journal of Dirty Fucking Hippie Economics, it's part of the Wall Street Journal. On the other hand, they actually have to provide their business readers with useful information, as opposed to misinformation.
This is very encouraging. Odd where one finds encouragement....
"One of the key innovations of the last century--and unappreciated, not to mention unknown, by most--is fiat currency: we are not on the gold standard anymore."
Minor point. Fiat currency was not an innovation for America in the 20th century, it was an innovation of the 17th century (the 1690s in Massachusetts). (Other forms of fiat currency were older, too.) The colonies were starved for cash because of England drained money from them. Adopting fiat currencies allowed commerce to flourish, despite that. One of the causes for the Revolution was that in the 1760s England prohibited the colonies from making "Colonial Scrip" legal tender. (British creditors did not want to be paid in inflated paper money.) The hyperinflation of the Continental was a major reason that the U. S. did not start out with a fiat currency.
Modern opponents of fiat currency fear hyperinflation. The main reason for inflation of colonial fiat currencies was war, and it was the main reason for the hyperinflation of the Continental. British counterfeiting was another reason. Another was that the Continental Congress did not follow the advice of Benjamin Franklin and support the Continental by taxation. We not only support our currency by taxation, the Fed takes action to control inflation, and has done so successfully despite our wars. :)
@Min is right to highlight hyperinflation during America's revolution. By 1781, the colonies' Continental currency was worthless.
See "Dismal Science (Part 2)": http://wp.me/pZiAD-Na
Yay! Someone in the mainstream finally gets it!
@inflation at high unemployment
"Inflation occurs when there is more demand than supply and this simply isn't going to happen when there is 8-10% unemployment."
It can happen. Inflation is not only the result of demand/supply imbalance, it is also the outcome of inflationary expectations. Poland had high unemployment in the 90s but it took many years to reduce the inflation to sane levels (below 10%) from the hyperinflation of the 1990 (when it peaked above 500%).
Also, if the unemployment is structural (again, think about post-Communist countries in the 90s), you cannot just print money and get people to work. You'll raise inflation but won't reduce the unemployment, as there is no useful work these people could do RIGHT AWAY.
I'm just nitpicking, because these points do not apply to the US in 2011. But they might in the future.
The Philips Curve model is not true in general, as the stagflation of the 70's clearly shows. It's based on a special case when demand pull inflation is occurring. Demand pull inflation isn't the only kind of inflation, there is also cost push inflation due to shocks.
Also, saying that a government can inflate its currency to arbitrarily high levels is absurd. Historically, governments that have attempted to create seigniorage from their currencies to excess have faced hyperinflation as a result (e.g., Zimbabwe, the Weimar Republic, and the above mentioned Poland).
You are right to think that there is little danger of inflation in our current situation, but not because orthodox monetary theory is wrong. Instead, we're in a rather classic case of a liquidity trap where the demand elasticity of supply is zero or close to it. See Krugman's writing on Japan for some more info on that.
Fred at Slacktivist has a great explanation for this:
You can't imagine the USA as a household that's just running over budget and needs to make cuts. That's not where we are. We're a household that's unemployed, and we're talking about selling the car in order to buy groceries and saving on the water bill by not showering any more instead of, say, finding a job, or maybe picking up some overtime if we're just underemployed. Yes, if we sell the car, that will provide us with some money right now, and not showering might help stave off an eventual financial collapse - but it will make getting employed, increasing our actual revenue, significantly harder later on (primarily because the United States' public transit system is in such a deplorable state, but that's another rant entirely).