Optimal fiscal policy

June 17th, 2015 at 1:31 pm

I testified in the House Budget Committee this AM and have many excellent war stories to share. But no time to do so now. Until then, please read my testimony, to which I devoted some thought.

Roughly speaking, the position of the majority R’s is that you should always balance the budget for…I just sat with these folks for two long hours and I can’t really finish that sentence.

Partly for moral reasons. One witness blamed “Keynesianism for the decline in beneficial ‘Victorian fiscal morality.’” Another had a macro-model that maintained, contrary to the CBO’s analysis of the R’s budget resolution, that the deep near term cuts would boost, not hurt, growth, because forward-looking households would realize that R spending cuts would eventually lead to greater investment, more tax cuts, and higher incomes in the future, so they’d spend more today to offset the cuts.

One member, touting the folk’ism that since families have to balance their budgets, the Feds should too, took issue with my point that in fact, families borrow long-term all the time for things like college and homes. He asked me if I make more than I spend. I told him I certainly went into debt to pay for college, and he said he did too!

Another R member went on about how much he hated government debt and I had the chance to ask him, “so, why did you guys pass $570 billion in non-offset tax cuts?!” I think he answered, not unreasonably, something like, “well, maybe that’s something we can put on the table.”

And so on.

Here are my bullet points:

  • The idea that the budget should always be in balance actually runs counter to optimal fiscal policy in an advanced, dynamic economy like ours. Instead, smart fiscal policy must be flexible, with deficits temporarily rising in recessions to support the weak economy and coming down in recoveries as the economy strengthens.
  • Elevating the goal of a balanced budget above other fiscal priorities risks doing more harm than good. The failure of European austerity — with those countries choosing fiscal consolidation in the context of weak economies — provides strong evidence to support this claim.
  • In contemplating questions about fiscal policy, we must never forget the core purpose of federal taxing and spending: to provide the American people with the government services and public goods they need, want, and deserve.
  • We must carry out this core purpose in a way that is fiscally responsible. At the same time, any benefits of fiscal consolidation must always be weighed against this essential government function. Are we disinvesting in critical public goods, like transportation or human capital development? Are we adequately pushing back against market failures like cyclical downturns? Are we providing those who’ve aged past their working years with adequate retirement and income security? Are we helping the least advantaged among us to meet their basic needs and to get a foothold on the ladder of upward mobility?
  • The answers to these questions imply that we cannot achieve a sustainable budget, where “sustainability” includes strengthening our economy and achieving broadly shared prosperity, solely by cutting spending. Policymakers, including many on this committee, have understandably raised serious concerns about the reckless cuts engendered by sequestration. The recent Republican budget resolution calls for far deeper spending cuts, which would undermine the essential roles government should play.
  • Some argue that because families and states must balance their annual budgets, the federal government must also do so. These analogies are wrong for two reasons. First, neither families nor states really have to balance their budgets; families borrow for various investments and states don’t have to balance their capital budgets, so the analogy is faulty. Second, the fiscal lesson to take from this framing of the argument is precisely the opposite of the one often drawn: the fact that states must balance their operating budgets actually provides a stronger rationale for the federal government to temporarily expand budget deficits in downturns.
  • Recent Republican budget plans only achieve balance through a) excessive spending cuts that violate the principles articulated above and b) gimmicks that ignore the impact of large tax cuts that are not offset. Implementing these proposed budgets would thus gut valued investments, reduce economic security, and harm prospects for jobs and wages, while doing much less to reduce deficits and debt than proponents claim.
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11 comments in reply to "Optimal fiscal policy"

  1. stanfrommarietta says:

    Jared, excellent testimony. It is so sad the ignorance of these people who supposedly know something about how to govern at the federal level.
    Anyway, there is an equation for monetary flows that I have taken from hydrology that applies:

    IF – OF = ΔC
    Inflows minus outflows of money into and from circulation equals change in quantity of money in circulation. Expanding that to take components of Inflow and Outflow into account we get:

    [E+(G’+D)+I+L) – (M+T+S+P) = ΔC
    E = exports
    G’ = portion of government spending equal to tax revenues
    D = Deficit spending
    I = Investment
    L = bank loans
    M = imports (money draining out of circulation into foreign dollar accounts)
    T = tax revenues
    S = saving
    P = payback of bank loans

    Now, let us add something here: C’ This is the quantity of money in circulation when there is full production of goods and services and full employment at stable prices and wages.

    Assuming that money is fungible we can get the same inflows and outflows respectively with different quantities for the components of IF and OF.

    For an economy that is growing but not yet at full production and employment at stable prices and wages, ΔC should be made to be positive by efforts to make IF > OF. Usually the greatest flexibility is in being able to manipulate deficit spending to whatever quantity we need to make IF > OF.

    We should run with ΔC > 0 until C rises to the level of C’.

    The analogy is with a reservoir or swimming pool with multiple inflows and outflow drains.
    If you adjust the inflows that you have control over to make more inflow than outflow, the pool will fill with water until it is full at C’. At this point you should balance inflow against outflow, that is, make IF – OF = 0 or ΔC = 0. Any continuation of more inflow than outflow will cause the pool to overflow and make a mess. As the pool overflows, you need to increase outflow to be greater than inflow to cause the excess water to drain out and return C to C’.

    In monetary flows, inflation will occur when C rises beyond C’, which will come from keeping ΔC >0 past C’. With excess money in circulation and production of goods and services already maxed out, more goods and services cannot be produced to absorb the excess money at stable prices. Those with more money will bid up prices to get the goods, hence inflation will occur. What is needed is to ‘drain’ circulation of the excess money.

    Getting the excess money into various savings, buying imports, taking it up with excess taxes, paying off loans will all serve to drain this excess out of circulation and return the economy to full production and employment at stable prices and wages. For example, the Fed can increase saving by selling securities it gets from Treasury in swaps of mature securities the Fed has bought for new securities. The Fed puts the money received in time-deposit savings accounts at the Fed. Later it can return the time deposits in return for the securities from the holders of them. Treasury can similarly create new securities and sell them to investors to drain money out of circulation into time deposit saving accounts at the Fed. (These constitute the greatest part of the ‘national debt’, of which the deficit spending ‘debt’ is only a very small portion of, on the order of about 4%).

    Anyway, I have an essay on this at stanfrommarietta.hubpages.com, so readers can turn to that also.

    Now, this equation in its expanded form shows the folly of just balancing the fiscal budget.
    We have been running continuous trade deficits, with more dollars leaving circulation through imports than coming back from exports. There is a continuing drain of money from circulation. That is deflationary, making C < C'. Not enough money is circulating to clear the market of goods and services produced. Vendors have to lower prices to clear the market. Manufacturers will have to lay off workers because they are getting less income from sales to justify keeping all the workers employed. With less workers working and earning incomes, even less goods and services will be bought, so there will be a downward spiral until inflow equals the outflow again. But that will be at a point where there is less production and less employment and poverty.

    Now the stupidity of balanced budgets where government spending always equals tax revenues on hand, is that this can occur when imports are draining continually money out of circulation. IF < OF because E+G'+I+L 0, deficit spending of newly created money. (Banks create and lend it, Treasury spends it, and Treasury does not ever pay back the principal, but rolls over the ‘debt’ by issuing new securities with new future maturity dates and swapping these for the mature securities used from deficit spending along with added in interest.

    Treasury also gets the interest money in the same way as deficit spending money, by borrowing from banks with securities as IOU’s. These securities will also be rolled over forever, never extinguishing the debt, which makes it not a true debt. After all, banks make loans out of thin air anyway, so all they want is the interest as debt-free money, and don’t care about getting the principal back.

    Or instead of deflation as our preceding example considered, we can have inflation and a balanced budget if exports are sufficient to overwhelm an economy that otherwise has a balanced budget of spending equal tax revenues, normal saving, and regular repayment of bank loans. Australia even ran a budget surplus for years without inflation because exports of iron ore to China were sufficient to substitute for government spending. In fact the surplus meant more taxes were retained than spent, so this countered the potential inflationary effect of the high export incomes to Australia.

    What these ignorant politicians don’t realize is that there are several sources of inflows into the economy and several drains of outflows from it. And the aim is not to just achieve a fiscal balance but an economy at full production and employment at stable prices and wages, at which inflows of money will be adjusted to equal outflows to maintain a stable level of money in circulation.

    • stanfrommarietta says:

      There is an error in the above comments. I don’t know how it happened. But at “Now the stupidity of balanced budgets where government spending always equals tax revenues on hand, ….” the following should be:

      “Now the stupidity of balanced budgets where government spending always equals tax revenues on hand, is that this can occur when imports are draining continually money out of circulation. IF < OF because E+G'+I+L M+S+P, deficit spending of newly created money. (Banks create and lend it, Treasury spends it, and Treasury does not ever pay back the principal, but rolls over the ‘debt’ by issuing new securities with new future maturity dates and swapping these for the mature securities used from deficit spending along with added in interest.”

      • Wondering says:

        I like where you’re going with your thoughts. You are making sense of the effect of the trade deficit.

        I think you’re going a little bit off track when you conflate money supply with inflation and recession. All money is not equal — it depends upon who holds it and whether it is wealth or just a medium of exchange for the holder.

        The damage of a trade deficit is that all of the dollars that flow overseas are draining our system of consumption dollars, not just dollars.

        As a result we also lose private investment dollars to foreign investments. The investment that comes back from other nations is occasionally private most mostly just government bond purchases — so if the government doesn’t spend that money (on consumption and investment), recession is quite likely.

        Money is not fungible. What does this mean? It means that in a macro sense, looking at money supply is not very informative. Much of the money in existence today is just debt on previous consumption. If the rules were written properly, in a recession those loans should be written off into thin air. It isn’t circulating in any real sense, only the interest is circulating. This is the major disconnect that occurred when we went off the gold standard but retained fractional reserves. None of the existing literature understand this.

        The goal of monetary policy should be to increase investment rather than consumption. Consumption based on credit if fine if the consumer is balancing out some temporary income problem, but when they do it out of necessity over the long term, it slows the economy over the long term.

  2. pgl says:

    Excellent! Could not have said any of this better than you do. One question – how uncomfortable were the Republicans on that committee as you told them the clear truth?

  3. john says:

    And then there’s my fave reason to engage in public spending, one that even the Dems dare not talk about: gov’t often has access to higher return investment projects than privates, especially at the zero lower bound or below full employment, but also, counter intuitively, at the peak of hot economies, since private ROI is actually low at that point.


  4. Dan says:

    God’s work Jared

    “Public spending should be made on goods and services that the private market will either not provide, for sound business reasons, or will not provide in optimal amounts.”

    I wish you would write a whole article blog or book about this and pound it into the public consciousness.

    This is so important. Government done right doesn’t compete with the private sector it HELPS it. of course individual citizens benefit enormously from Government done right, but corporations, business and the wealthy do as well (though their relative wealth is hurt).

    The free market doesn’t incentivize the production of every economic output! Its not a competition between government and business. ughhh,

    The idealogues who have embedded in the public discourse the free market good, government bad meme that everyone knows, just knows is true because Adam Smith said so have done enormous damage.

    • Richard says:

      Many who believe in the myth of Adam Smith have never read or understood his works. He railed against monopolies (cartels and guilds) and especially against the Crown granting monopolistic charters, but so would you and I. And his views of businessmen and of the role of government in general is nowhere nearly as right-wing as the right-wingers think. Here are three quotes from Wealth of Nations.

      “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

      “[T]he mean rapacity, the monopolizing spirit of merchants and manufacturers, who neither are nor ought to be the rulers of mankind, though it cannot perhaps be corrected, may very easily be prevented from disturbing the tranquility of anybody but themselves.”

      “The [government] has only three duties to attend to … [T]hirdly, the duty of erecting and maintaining certain public works and certain public institutions, which it can never be for the interest of any individual or an small number of individuals to erect and maintain; because the profit could never repay the expense to any individual or small number of individuals, though it may frequently do much more than repay it to a great society.”

      • Dan says:

        Yes, there are two problems of course. First as you point out, Smith was a deep and nuanced thinker and simple aphorisms don’t reflect his thinking.

        Secondly, and I think more relevant, it doesn’t really matter what Smith thought. What matters is what is right. Smith or anyone else is just useful in as much as they illuminate our understanding of how the world works.

  5. Wondering says:

    The empirical macro data is pretty compelling also. Every time the US government balances the budget or runs a surplus, it is followed quickly by a major recession. These are intimately connected occurrences.

    Government bonds provide a very safe, savings/investment vehicle for a lot of citizens that don’t trust Wall Street to invest their money for them. When deprived of that savings vehicle, that money tends to flow into speculative investments that fuels asset bubbles that later collapse.

  6. Jill SH says:

    Is your testimony on C-Span? That way I can listen while I work…