Saturday, May 29, 2010

For the opposite view...

After writing the previous post on why budget deficits are a negative thing for the economy I stumbled upon an article that justified them. The Levy Economics Institute of Bard College recently released a Public Policy Brief on why we should stop worrying about U.S. Government deficits. The authors Yeva Nersisyan and L. Randall Wray point out that a budget deficit is just a transfer from the government to the private sector and that surpluses are the exact opposite net transfers from the private to government sector.
Furthermore, they dispute the often heard claim that deficit spending today burdens our grandchildren:

"in reality we leave them with government bonds that represent net financial assets and wealth. If the decision is made to raise taxes and retire the bonds in, say, 2050, the extra taxes are matched by payments made directly to bondholders in 2050”

Today's deficit leads to debt that must be retired later, and future tax increases that are supposed to service tomorrow's debt represent a redistribution from taxpayers to bondholders. Although this may be undesirable given that bondholders are wealthier than tax payers, but if one takes into account the U.S. progressive tax system it may just represent a transfer from taxpayers back to taxpayers. This is a reasonable perspective given that we as public bondholders get repaid even if it is a discriminating redistribution of income taxes back to rich people who could afford the bonds from poor people may not hold any bonds.

A government deficit is a transfer of income from the government to the private sector in the form of non-government income.

"A government deficit generates a net injection of disposable income into the private sector that increases saving and wealth, which can be held either in the form of government liabilities (cash or Treasuries) or noninterest-earning bank liabilities (bank deposits). If the nonbank public prefers bank deposits, then banks will hold an equivalent quantity of reserves, cash, and Treasuries (government IOUs), distributed according to bank preferences."

A surplus has the opposite effect as increased tax revenue from the private sector lead to a reduction in wealth and in order to maintain the same standard of living the private non-government sector has to borrow more.

"A government budget surplus has exactly the opposite effect on private sector income and wealth: it’s a net leakage of disposable income from the nongovernment sector that reduces net saving and wealth by the same amount. When the government takes more from the public in taxes than it gives in spending, it initially results in a net debit of bank reserves and a reduction in outstanding cash balances."

One important argument made is that the largest part of the current deficit results from automatic stabilizers like transfer payments and unemployment benefits. The flipside to increased unemployment benefits as the economy goes through a contraction is their tendency to fall back down as the economy recovers. As the leading driver of the deficit they are also the main reason for the reduction in the debt/gdp ratio as the economy expands. Along with increased unemployment, tax revenues that fall during the recession pick up during the expansionary phase.

In defense of Obama's stimulus:

"These automatic stabilizers, not the bailouts or stimulus package, are the reason why the U.S. economy has not been in a free fall comparable to that of the Great Depression. When the economy slowed, the budget automatically went into a deficit, placing a floor under aggregate demand."

After reading this article, one highly theoretical argument that I can make is that if the United States was forced to monetize part of the debt it could raise interest on reserves to soak up any additional liquidity created in the system. This would represent a massive transfer of Government debt from the Treasury to the Fed in the form of excess reserves. The excess reserves could then be manipulated with the appropriate raising and lowering of the interest paid on reserves relative to the federal funds rate. This is quite an exciting premise that represents an internal transfer of funds by the U.S. Government that would keep inflation expectations stable while also calming the fears of deficit hawks.

Tuesday, May 25, 2010

Welcome to X.U. Economics/ Dangerous Defict

Hello y'all and welcome to the Xavier econ blog. This blog will be maintained by X.U. economics faculty and students, and will provide information on a variety of interesting topics in economics. Unfortunately for the world right now, one of the most fascinating yet dangerously risky current events just happens to be a global debt crises.

The world is on the verge of a global disaster. Just last week we saw Germany ban naked short selling, a sign that things are clearly only getting worse.

Before that investors around the world started closely watching the Greeks and their fiscal dilemma. That is also when I started watching. Greece was the first sign of a much deeper rooted issue. Greece was just the most over-leveraged of the euro-zone economies, and it revealed that countries similar to it would be endangered as well. If we look with our binoculars we can see that across the pond the whole euro-zone is panicking right now, and as they should be. Excessive budget deficits tend to erode confidence in the government. Whether in the United States or Greece the same principle holds regardless of economic status.

Confidence is very important to financial stability because everything is based off of future profits and cash flows. If confidence in the United States ability to pay back its debts and pay off its treasury notes erodes then we have a problem.
If the United States doesn't bring down its deficit:
A. The ratings agencies will see that debt/gdp ratio is outrageous, and will notice that the deficit is ballooning due to:
1. Lack of foreign demand for domestic goods which leads to decreased tax revenue
2. Rising interest rates since the Fed will have to raise the federal funds rate eventually
3. Reduced government cash flows due to a diminishing tax base with the high unemployment
4. Increased health care costs
5. Increased automatic stabilizers like transfer payments

B. The ratings agencies will then decide to downgrade U.S. Government debt which will lead to:
1. An increased budget deficit
2. Much higher interest rates
3. A massive sell off by all the major holders of U.S. Government debt, ( Many pension and insurance companies have it built into their computers to automatically sell bonds that are not AAA rated)
4. A further downgrade of U.S. debt
5. A massive sell off by China

For those of you who are still skeptical (most of you will be) read this speech by our Chairman of the Federal Reserve, it should help put some things in perspective. One thing to keep in mind is that when the Central Bank Chairman warns about fiscal sustainability it is usually a sign of too little will be done and whatever is done will be much too late in the game to make a difference.

As Ben puts it,
"The path forward contains many difficult tradeoffs and choices, but postponing those choices and failing to put the nation's finances on a sustainable long-run trajectory would ultimately do great damage to our economy."