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Archive for July 2010

Inflation: What Really Causes It and What We Truly Have to Fear

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I’ve been putting off doing this one, in no small part because we don’t have a problem with inflation at the moment. However, since a) people are starting to talk about it as a possible consequence of the debt/deficit and b) it is the only economic concept that I think is even less properly understood than the aforementioned debt and deficit, I thought I’d type something up. It’s actually not all that terribly complicated but is misunderstood for the same reason the budget deficit is: people try to think of what is going on in micro terms (the individual household) rather than macro terms (the whole country). That’s understandable since these people aren’t professional economists and you naturally use what you know as your reference point. What is extremely difficult to understand is why so many of my colleagues are also in the dark on this issue. And what’s downright dangerous is the fact that so is the Federal Reserve.

What are the causes and costs of inflation?

Let’s start with just thinking about the household since that will be familiar. Say you have a family, the Microns, whose annual income is $50,000 and the average price of whatever it is they purchase is $5. In that case, they can buy 10,000 “things” every year: 10,000 x $5 = $50,000. In economics, we would call the $50,000 the Microns nominal income and the 10,000 their real income: on the paycheck it says they earn $50,000, but what the really earn is 10,000. And now, to make the math simple, assume inflation of 100% such that by next year, the price of the average thing rises to $10. Now the Microns can only buy 5000 things. Their nominal income is still $50,000, but real income has fallen to 5000. That’s inflation and by this story the cost is obvious and it appears that inflation is unequivocally bad. The only problem is, it’s wrong. To understand why, you have to take a macro view.

Think about this for a moment: if the Microns were paying twice as much for each thing they purchased, where did that money go? Into a sinkhole in Florida? Of course not, it went to another family (or business–but then that ultimately goes to a family, too). This is because the prices the Microns pay represent the income another economic entity is earning. This is the true impact of inflation: it is always and everywhere a redistribution of income. If the microns real income has halved, someone’s (or some combination of people’s) has doubled. Rising prices mean, for others, rising incomes. It is mathematically and logically impossible for it to be otherwise since when you pay more, someone gets more–there is someone standing on the other side of that cash register If you pay more, someone gets more. If you pay more, someone gets more. If you pay more, someone gets more. I’m saying this over and over because it is so poorly understood, even in economic theory, and to understand what follows you need to keep it in the front of your mind. Rising prices = rising incomes.

In fact, if all prices rose by 10% at the very same time as all incomes rose by 10%, it would be inconvenient but would otherwise have absolutely no impact on people’s real incomes. But, of course, that never happens because the inflation has to start somewhere and some prices are affected more than others. Just think about the 1970s and the early 1980s as the classic example. This was a period of terrible inflation. Look at the numbers below (I left a bit of the 1960s in for reference):

US Inflation
1968 4.2%
1969 5.4%
1970 5.9%
1971 4.2%
1972 3.3%
1973 6.3%
1974 11.0%
1975 9.1%
1976 5.8%
1977 6.5%
1978 7.6%
1979 11.3%
1980 13.5%
1981 10.4%

These were unprecedented numbers and you keep having to remind yourself that the increases compounded–the relatively moderate 5.8% in 1976 was on top of 9.1% the year before that, which was on top of the 11% the year before that, and so on. And this inflation was a worldwide phenomenon. People across the globe were paying higher prices for the goods and services they purchased. Of course, these increases were not uniform and the prices of some goods and services may have fallen. But, on average, there was a large increase.

Did everyone’s standard of living across the globe decline? You are probably already way ahead of me on this one and you know that the answer is clearly and emphatically “no.” Some folks were much better off, because even though the prices they were paying had risen, their incomes had risen far more. That’s because the amount of money they earned was a direct function of those prices that had risen most: those for oil. For the oil industry and oil exporting countries, this was a magnificent period. Their incomes were rising at the expense of those not in the oil industry. Income was being redistributed to them, and that’s how inflation works. Prices start rising in one sector, pulling extra income towards it. The sets into motion a chain reaction, raising some, but not all, other prices. The inflation we report in the news is just the average: the winners saw the prices of what they sell go up by more than the average, while the losers saw their prices rise by less (or even fall). It’s always this way (though it’s easiest to see in the 1970s because the source of the inflation is so obvious).

Not that this is necessarily a bad thing. Think for a moment about the reasons a price can rise. Maybe demand has increased. Why shouldn’t you make more money for selling something people want? Good for you, that’s what capitalism is supposed to be all about. The rising prices enrich you, they encourage others to sell whatever it is you are making, and it causes consumers to look for substitutes: all of these are useful reactions in terms of how the free market is supposed to work. This is, incidentally, what economists call demand-pull inflation (because demand pulls prices up). Hence, if the huge jump in oil prices in the 1970s was simply because driving your car became much more popular, then so be it.

But there are other reasons the price could rise, which generally fall under the category of cost-push inflation. In these cases, basic costs of production cause a rise in the price. I remember reading in an economics textbook of the example of anchovy fishing off the coast of Portugal. Apparently, anchovies are not juts for pizza. They are also a major part of cattle feed. One year, for some reason the anchovies didn’t show up in their usual places and so the harvest was very light. Since there had not been a chance in the demand for the tiny, salty fish, this caused a rise in price. It cost cattle-feed manufacturers more to produce cattle feed, meaning that ranchers had to pay more, too, and on down the line. The fact that the anchovies didn’t show up caused inflation, which affected the incomes of those involved. Who won or lost in this case gets more complicated than in the above scenario as it will depend on various elasticities and other parameters, but clearly standards of living are affected. Again, however, this is what the market is supposed to do. If the supply of a resource changes, prices need to change to create the appropriate incentives (to find new sources, develop alternatives, etc.). This is something that happens in an otherwise healthy capitalist economy–and it’s not what happened in the 1970s. The rising prices were not a result of us running out of oil.

There is a second kind of cost-push inflation, however, one that is a function of market power. Market power is the ability to avoid competition (for an extended discussion, see my posts on the health care industry: This is a bad thing. The problem is that business people are greedy. As the father of capitalism, Adam Smith, wrote:

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.

Dirty bastards! Many people think of capitalism as a pro-business system, but it’s quite the opposite. Set up properly, it leaves business as powerless, at the mercy of the folks that Adam Smith really wanted to see in charge: the consumers (again, there is a much more detailed discussion of this under health care reform in this blog).

Of course, businesses, consistent with Adam Smith’s characterization, do what they can to avoid this. It is obviously a lot more fun to be a monopoly than to be in competition, and they will do what they can to get as close to their ideal as possible. It is the job of government policy makers and economists to make this difficult (hence the existence of anti-trust laws, for example). It’s a never-ending battle, and you win some and you lose some (part of that battle is businesses and their lobbyists arguing to the general public and politicians that capitalism is about making life easier for businesses–ha, now you know better!).

Again, you are probably ahead of me on this: those businesses successful in gaining market power for themselves can raise prices, and this causes inflation and a redistribution of income towards those with the market power. However, unlike the other two cases above, there is not underlying good here. It serves no greater economic purpose to have those who have avoided competition get more of your money. If someone gets rich by facing competition and winning, good for them. They must have been selling something other people wanted when they had a choice. But, that’s not the case here, and it’s not just firms who can have market power. So can workers and, in some cases, countries. And now we are finally to an explanation of the 1970s.

Four letters: OPEC, or Organization of the Petroleum Exporting Countries. It’s a long (but fascinating, in no small part because my first love is military history) story as to how they came to decide to exercise their power at the close of 1973. In short, they, being primarily Arab nations, were very upset with US support of Israel in the 1973 Arab-Israeli War (which the latter came perilously close to losing). This gave them the focus to agree on how they would go about raising prices by voluntarily reducing supply. You can have a glance at the results here:

Saudi crude oil jumped from $2.10 in 1973 to $9.60 in 1974. By 1982, it was $34. This was not demand-pull and it was not the kind of cost-push related to acts of God (like anchovies not showing up or hurricanes destroying resources). It was market power, pure and simple, and it was a massive redistribution of income to OPEC countries and oil companies. It served no useful purpose (unless your goal was to see the West punished for helping Israel–it certainly did that).

These are the three kinds of inflation. I’ll call them demand-pull, cost-push/act of God, and cost-push/market power. All three redistribute income, but the first two do so on a basis that makes economic sense. They enrich those who should be enriched and thereby create signals for entrepreneurs and consumers regarding what should happen next. If the prices of lumber go up because there has been a massive boom in housing, then the fact that lumber manufacturers get more money acts as a signal to others to enter that industry (which is what consumers want) and it is an incentive to builders to find a substitute for lumber. If the prices rise because a forest fire burned down our trees, it still makes sense for lumber prices to increase. That’s the appropriate signal to the market. Only inflation created by market power is clearly harmful. We should stop it. But how? What policies are available to us?

Policies to prevent inflation

The obvious way to stop demand-pull inflation is to lower demand. The government could, because there is a housing boom leading to bottlenecks in the building industry, throw the entire macroeconomy into recession. That makes little sense, however, because demand-pull inflation sends appropriate signals and redistributes income on a logical basis. And, anyway, it’s hard enough to get the economy in expansion without causing recessions on purpose. What moron would do that!? (HINT: The Federal Reserve. More on this in a moment.)

With cost-push/acts of God, there is little that can be done (prayer?) directly and, besides, the price changes make sense. The government could act to make any transition easier, but if there ain’t no anchovies, there ain’t no anchovies.

Cost-push/market power is bad, about that there is no question. Unfortunately, while solving it in theory is very easy (get rid of the market power!), doing so in practice is messy. You have to directly address the problem, meaning that you’ll have to fight some business, labor group, country, or set of countries that really, really like having market power. If it’s one of the first two, they’ll line up their lawyers and economists and fight it out with the government’s. Who wins is an open question. Not that I am suggesting that we shouldn’t do this–we absolutely should, the survival of capitalism depends on making sure that accumulations of market power like this do not occur. They will because those greedy business people are also smart. But, we have to fight back. Unfortunately, there is no magic wand we can wave to make it all better. The only basic defense here is a general understanding on the part of citizens and their government that this is a constant problem, one for which we must remain vigilant. It’s funny that Americans, to whom democracy is supposedly such an important ideal, have very little trust for their democratically-elected government and yet at the same time have such faith in the market system. In terms of giving power to the people, it works just about as well as democracy: it’s not terrible, but it’s certainly not perfect. Keep a close eye on both.

Policies we actually employ

I entitled this post, “Inflation: What Really Causes It and What We Truly Have to Fear.” What I’ve said so far is that demand-pull inflation and cost-push/act of God are reasonable responses to economic stimuli but that cost-push/market power is all-around bad. However, my reference in “What We Truly Have to Fear” was not to market power, but to the Federal Reserve. In the US (and most other countries), policy does not follow what I’ve discussed above. Cost-push/market power inflation is almost completely ignored (maybe this is starting to turn around again, but since the 1980s we have had a very lax anti-trust attitude in the US) and it has been demand-pull inflation that has been made out to be the villain. The economists at the Fed see it as their job to force the US economy into recession when they see demand-pull inflation threatening–and they see all inflation as demand-pull. Hence, they act to stamp out expansions in response to the perfectly reasonable response of the market to increases in demand (I have a whole class in how they would have developed such a theory, but it’s a bit much for the blog).

If you are old enough to remember the early 1980s, you may recall the incredibly high interest rates. This was on purpose, a policy response of the Voclcker Fed to the inflation caused by OPEC. It caused the worst recession since the Great Depression (a title it only lost very recently!). Unemployment skyrocketed from 5.9% in 1979 to a peak of over 10% during 1982. This was all done on purpose in order to control inflation that they viewed as demand pull. It was, of course, not.

Unfortunately for those of us uncomfortable with the government causing unemployment on purpose (and for no good reason, assuming there is a justification for such a policy), it appeared to work. Here’s the last bit of the numbers above, with a few more tacked on:

US Inflation
1978 7.6%
1979 11.3%
1980 13.5%
1981 10.4%
1982 6.2%
1983 3.2%
1984 4.4%
1985 3.5%
1986 1.9%

WOW! 1.9% inflation! That’s incredible given what had preceded it! It looks like we should give the government carte blanche to cause the worst recession since the Great Depression whenever they need to! After all, demand-pull inflation is terrible since it enriches people who sell things that others want and it creates appropriate signals to entrepreneurs and consumers.

What this story leaves out is the following. First off, our hands are obviously tied when it comes to market power being a function of something that lies outside our legal jurisdiction, as happened with OPEC. We can find ways of making what they sell less important to us (as we did), but that’s about it. We can’t drag them before a Congressional committee and accuse them of anti-trust violations. Fortunately, however, we didn’t have to. They fell apart on their own.

On September 22, 1980, Iraq invaded Iran. The war, which resembled the Western Front in WWI but with missiles and jets (and included chemical weapons), dragged on for eight long, bloody, and terribly expensive years. With both countries in terrible financial straits, they started cheating on the OPEC agreements they had made (the agreements that had led to the high prices). And, if they were going to cheat, others decided to do so, too. Take a look at the figures again and see when the inflation starts to fall. And things got much worse for OPEC (and better for the rest of us!) as their agreements collapsed. Oil prices fell and inflation suddenly and miraculously came under control. What solved US inflation? Saddam Hussein’s dreams of empire, not Paul Volcker’s economic policies!

The debt, deficit, and inflation

I suggested in the opening paragraph that part of my motivation to write this now was because people were saying that the debt and deficit could cause inflation if we tried to pay them off by monetizing them (i.e., by simply printing money). I think this entry is probably long enough so I’ll be brief here. Two things: 1) printing money doesn’t cause inflation if the economy is not already at full employment, i.e., if we are not already at the point where we are at maximum capacity. Otherwise, it just creates jobs and output. 2) If it does create inflation, it’s demand-pull.

And that’s enough for today!

Written by rommeldak

July 22, 2010 at 7:31 pm

Posted in Uncategorized

Government Deficits as Necessary to Capitalism

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I thought I’d add a short addendum to my original post on the debt and the deficit so that I can drive home the central points.

  1. We have the ability to create plenty of goods and services, but, ironically, we can do so too easily. Because with our productivity we can satiate short-term demand without using the services of all those who are willing to work, unemployment is created. Even more results from the fact that no one is hired to produce the goods and services the redundant workers would have consumed, but now cannot afford. Because there is no profit in hiring any of those unemployed workers, the private sector is of no help in resolving this dilemma. Only a sector of the economy willing and able to spend without expectation of profit can help, which is, of course, the government. If they spend sufficiently to guarantee the hiring of the redundant workers, then this raises the overall standard of living without asking anyone to settle for less. In a capitalist economy, it is absolutely critical that the government play this role, that of the sector that is willing to spend without expectation of return, because it is the only one that can afford to do so. By acting in this way, they increase the real wealth of the nation, goods and services. Employment rises, output rises, tax revenues rise, and welfare and unemployment payments fall–deficits are ironically likely to be smaller than when the government foregoes this role (not that that’s really necessary).
  2. Government budget deficits add wealth to the private sector and allow firms and households to pay off debt and save; government budget surpluses drain wealth from the private sector, reducing the savings of firms and households and putting them in debt.
  3. Given 1 and 2, who would recommend that we should, in the midst of the worst economic crisis since the Great Depression–reduce the deficit? It makes no sense whatsoever, particularly in light of points 3 and 4:

  4. We did the exact same thing during the Great Depression with disastrous results. By 1936, we had finally reduced unemployment from 25% to 14% (can you even begin to imagine what that must have been like, particularly in the absence of all the social programs we have today?). But, there was a public outcry against what was, by today’s standards, a very small debt and deficit (and, just like today, people were calling it socialist and the destruction of America). The government heeded the call, and unemployment shot back up to 19%. It took three long years to get it back to 14% again (which is still well above what we have today). Shortly after that, WWII started, the deficit and the debt skyrocketed, and unemployment plummeted–and for some reason, no one was complaining! If we follow the same route (i.e., if we try to cut spending as we did in 1936), we are unlikely to be “saved” by a world war this time.
  5. The government is not a household and the essential logic underlying its operation is very different. Not only do they not need to balance their budget, we should not want them to do so. It is counter to the purpose they are supposed to serve. Consider this. In a capitalist system, members of the private sector cannot exist as viable economic entities if they are unable to convince other entities to give them something they are not allowed to make for themselves: dollars. In fact, they need to attract at least as many of these as the number they need to exchange for the goods and services they would like to consume–and hopefully more than that so they can accumulate savings. The means by which they convince other entities to give away their dollars is in exchange for goods or services. They key to the advantages of using a capitalist system is the word “convince.” If you want my dollars, then you need to make some good or service that I’d like to have (actually, this works properly only if several other conditions hold, relating primarily to the level of competition that exists, but I won’t go into that here–see my discussion of health care for more on that). Those who are successful must have been doing a good job creating goods and services other people like. Good. Those who go bankrupt aren’t doing things the rest of the society finds useful, and their bankruptcy acts as a signal: don’t sell what they are selling! That’s how the private sector is set up and, therefore, the fact that entities there can go bankrupt can, if everything else is set up properly, actually serve a useful purpose. It makes sense that we don’t allow private citizens or companies to print their own money becuase if we force them to make them earn it by selling things others are willing to buy, this creates wealth for all of us.  We don’t need the government to play this same role. It is supposed, in the first place, to do things that are inherently not profitable, but socially necessary: national defense, education, NASA, etc. Hence, by nature, the government is forced into a situation where it could not earn profit in the same way the private sector does even it wanted to. It cannot and should not play the same game. Second, because of the issue raised in point 1, we need it to generate more spending than it drains away in taxation. Taxes are a useful mechanism for altering spending patterns in order to achieve certain social and economic goals (giving tax credits for charitable giving, encouraging home ownership by making interest and property tax payments deductible, using a progressive system to keep income distributions more even and thus generate more consumer demand–the poor and middle class spend more of their incomes than the rich), but the government doesn’t actually need them in the same way WalMart needs to charge for stuff on its shelves. Why? Because the government, unlike agents in the private sector, may print their own dollars. The US government does not operate under the same sort of budget constraint and if they are to fulfill their role in society, they cannot. It’s not simply that it’s not set up like the private sector, it shouldn’t be–and the private sector is better off for it. Trying to understand the federal government budget process by thinking of it as a household or a firm is to commit a fundamental error of logic. They simply are not analogous. Unfortunately, because we are all so familiar with the way budgets work in our private lives, we cannot help but make the “obvious” but invalid leap.

Note, incidentally, that people are quite right to assume that state and local governments face a budget constraint similar to that of the private sector. The State of Texas does not print its own currency (at least not until we secede) and so if the state government does not collect in revenue as much as it wishes to spend, it faces a real problem. They can borrow, but repayment is a function of future tax revenues, period. They have no other option. Of course, if the deficits are financed by selling debt to Texans, then when the debt is repaid it is basically a redistribution of income within the state: taxes are collected from the population at large and some of those funds go to those who had purchased the bonds that allowed the state to spend in deficit. The situation in Greece was similar to that of a state or local government and hence has very little in common with the US. The primary difference is, they don’t issue their own currency–they are on the euro. Hence, Greece–which should never have been allowed entry into the EU because its periphery status almost guaranteed a problem like this would emerge–was put in the position of a private-sector firm. If they were going to pay their debt, they had to sell (export) more than they purchased (import).

The one and only useful purpose that the balanced-budget fiction plays at the federal level is this: it constrains the power of government officials who, if they realized there was no realistic constraint, might well go just a little crazy. I will not deny that this is a real issue. But, if the only means of solving it is to drain income from the private sector, causing unemployment and stagnation, then there simply is no hope. But surely not.

Say, maybe one of my earlier comments that realistic economic analysis cannot be reduced to something that fits on a bumper sticker is wrong:

Political Reform: Yes Budget Balancing: No

Written by rommeldak

July 15, 2010 at 1:02 pm

Posted in Uncategorized

Debts, Deficits, and Dummies

with 2 comments

There is so much misinformation floating around about debt and the deficit that I figured I should write something about it in my blog. One of the things I find most disheartening about these ill-founded discussions is that professionals as well as amateurs are contributing to them. With the possible exception of inflation, I’m not sure there is another area of economic analysis where scientific skepticism and objectivity are more rapidly abandoned in favor of a knee-jerk acceptance of folksy wisdom than the government budget. Unfortunately, getting it right is extremely important, especially right now.

Let me begin by taking a quote from a blog entry on deficit myths written by Randy Wray. It sums up very nicely the problems we, as professional economists, face in discussing this issue:

I was reminded of a conversation I once had with the late and great Robert Heilbroner about my book, “Understanding Modern Money”. He warned me that the book was going to scare the living daylights out of readers (actually he used more colorful language—but it was a private conversation, not a public blog fit for family viewing). He went on to explain that money is the scariest thing for most people, sure to result in heated and angry discussion. It is also complex, something everyone talks about but few understand. Hence, it is a topic that must be carefully addressed, and with plenty of reassurances that one is not propounding anything too unsettling. It is also a subject that accumulates more than its fair share of cranks—indeed, “monetary cranks” actually earned an entry in the New Palgrave dictionary of economics.

If he is right that discussing the debt is frightening, then maybe a good way to start is to clear our heads by simply jotting down some relatively non-controversial facts. It’s also a bit complicated, I’m afraid. But, most important issues don’t boil down to something you can fit on a bumper sticker.

* The government spends money on goods and services ranging from tanks to public parks (an excellent overall breakdown with plenty of options for analysis is available here: It represents around 40% of all spending in the macroeconomy.

*Since the beginning of the 20th century, government spending has ranged from less than 10% of total GDP (early 1900s) to over 50% (WWII). It is currently around 45%.

* The government raises funds through taxation. At the federal level, the biggest chunk is from individual income taxes and payroll taxes (over 80%).

* When the government decides to spend more than it raised, this creates a budget deficit (as opposed to the trade deficit–two different things). To close this shortfall, they sell IOU’s (primarily in the form of Treasury Bills). These are sold at auction to whomever wants to buy them: Exxon, Citibank, the Federal Reserve system, Fort Worth city government, your grandmother, your neighbor, or China.

* The accumulation of all previous deficits, minus any surpluses, is the total national debt.

* While the overall dollar value of the debt has never been higher, the ratio of national debt to GDP has been. Note first that the latter is a far more meaningful measure. To know that one family has $10,000 in debt and another has $100,000 does not really give you a sense of the burden on each. You really need to know their incomes. It might well be that the latter family is in a much more stable financial situation. Returning to the debt, as a percentage of GDP, it has ranged from around 10% (early 20th century) to almost 130% (end of WWII). It is currently around 100%.

* After WWII, the 130% debt was reduced by half in about 15 years.

* As of 2009, the US ratio of debt to GDP was 47th in the world, behind (for example) Spain, Ireland, The Netherlands, Norway, the United Kingdom, Germany, France, Japan. The US was also below the world average (CIA World Fact Book). Russia has one of the world’s lowest debt-income ratios.

* A country does not default if it cannot lower debt to zero; it defaults if it cannot meet its monthly payment, so to speak. In other words, there is absolutely no logical reason that we must work to lower national debt to zero. We must, however, be able to pay those whose Treasury Bills have come due.

* The budget deficit automatically rises in recession and falls in expansion. This is so because in recession, there is less income and therefore less tax revenue. In addition, government spending automatically rises in recession because of the increase in unemployment benefits, welfare, etc.

* The US government debt is denominated entirely in US dollars.

* As of 2008, over ½ of all outstanding the US debt was owed directly to the US government (Federal Reserve system, intragovernmental holdings, and state and local governments–i.e., governmental agencies other than that which sold the debt in the first place, the Treasury). Around 1/3 was owed to foreign and international entities (both government and private). The rest is owned by private US firms and individuals.

* US government debt is an extremely popular form of saving worldwide because it is considered so safe (this is also why it pays such a low rate of interest).

Before trying to draw some conclusions from the above, here are some facts and figures regarding the trade deficit. I feel it necessary to mention this because there is a great deal of confusion between the two, particularly in the case of China. The bottom line of the discussion will be that the reason China owns so much US national debt is a function of our trade deficit, NOT our budget deficit. If the US government budget had been in surplus for the past 100 years, China would still own as much of our debt then as they do now. On to the facts and figures!

* When Country A sells goods and services to Country B, this constitutes exports for Country A and imports for Country B.

* If Country A exports more to Country B than it imports from them, it has a trade surplus (and Country B has a trade deficit).

* I’m afraid this is going to get a bit complicated, but it is a critical point if you want to understand US debt in China. Here goes…Country B cannot have a trade deficit with Country A unless someone in Country A loaned people in Country B the money to cover the difference. Think of it this way. When the US buys a good or service from the UK, they ultimately need British currency (pounds sterling) to do so. An American consumer may be able to buy a box of PG Tips tea at their local supermarket using dollars, but the employees and owners of PG Tips need pounds or they can’t go to their local supermarket and buy the groceries they need. So at some point in the process, American buyers needed to purchase pounds (with dollars) in order to purchase the tea.

Because, at the same time, Brits are purchasing boxes of Rice-A-Roni (one of my English cousin’s favorites!), they are facing the same problem but in reverse. So long as the purchases of PG Tips are equal to the purchases of Rice-A-Roni, things work out just right. There are just as many dollars floating around in the British banking system (as a residual from the US purchases of pounds to buy tea) as are needed by Brits to buy rice. They basically trade pounds and dollars back and forth so that they can trade tea and rice. But what if we start in equality and the British demand for rice suddenly rises? Britain needs more dollars to get more rice.

Assuming there is no change in the American demand for tea, one of two things (or a combination thereof) must occur. First, imagine the scene at the bank when UK importing company asks for more dollars to buy more US rice–there aren’t any to be had. The quantity was set by how much tea Americans bought from the UK, and all that is used up. Any excess caused by a British trade deficit must be financed. This means the British bank has to find dollars somewhere else. Britain must sell something to the US other than goods and services (i.e., rice). That “other” is a financial asset: shares of stock, corporate bonds, UK government debt, etc (note that outright borrowing money from an American bank is equivalent to selling an financial asset, too). This must be net, of course. Americans will also no doubt be selling financial assets to Britons, too. But if the trade deficit is to be financed, the UK must sell an excess of financial assets to Americans.

If Britons can find no American buyers for their financial assets then they cannot have a trade deficit. In that case, the market returns to equilibrium as follows. As there continues to be an excess demand for the dollar over the pound (due to the fact that more Britons want rice than Americans who want tea), so the dollar appreciates and the pound depreciates. This makes tea cheaper and cheaper to Americans, meaning they raise their purchases; and it makes rice more and more expensive to Britons, meaning that they cut theirs. This continues until we are again in the situation where Americans demand as much tea as Britons demand rice.

Thus, a trade deficit must be financed by sales of financial assets to the surplus country; if that does not occur, the deficit country’s currency will depreciate (and the surplus country’s appreciate) until the deficit is gone. Notice one more thing about this scenario: if the US is particularly enjoying having their trade surplus and they would rather not see the dollar appreciate and their surplus to dwindle, there is no need for them to wait for the British bank to speak up. They can rush over the “help” the UK by buying up their financial assets unsolicited. The US will have to do this continually to keep funding the new British trade deficits every time period, and the US will thus accumulate UK debt (and, after all, the US needs to do something with the funds they are accumulating from their trade surpluses). If the US does not actively pursue buying up British financial assets (stocks, corporate bonds, British government, debt–it doesn’t matter which one), then their trade surplus may disappear. Sound familiar???


Let me start with this since it’s what you just finished reading: the fact that China is accumulating so much of our debt is a function of our trade deficit with them. And they are hardly doing us any favors by “kindly” buying up our financial assets (largely government debt at the moment, but only because we happen to be running a budget deficit–it the T-Bills weren’t there, they’d be buying something else). It’s completely in their self interest. If they weren’t doing so, the yuan would appreciate and they’d lose their trade surplus. And if we had a trade surplus with China, then it wouldn’t matter how much the US budget was in deficit: we’d be accumulating their assets and not the other way around.

Incidentally, not many folks know which other countries hold big chunks of US debt (and only recently so–they had been #1 for quite a long time). Here are the data from the US Treasury Department web page (as of April 2010):

#1 China, with $900 billion
#2 Japan, with $796 billion
#3 United Kingdom, with $321 billion
#4 Oil Exporters, with $239 billion
#5 Brazil, with $164 billion

For comparison purposes, the US government owns $8290 billion of it’s own debt (($5260 billion for just the Federal Reserve and intragovernmental holdings).

Not surprisingly, Japan has had a trade surplus with respect to the US for many years, as has the UK until very recently. If these countries didn’t own lots of US government debt, they’d own lots of Exxon or Walmart, instead. One way or another, a trade deficit with a country means that they will accumulate your financial assets. Reducing your budget deficit or national debt will have no effect on the size of the assets they own, only the composition.

This is not to deny the fact that China does, indeed, own a lot of US debt (though note that Japan and the UK added together own more, and all of them are dwarfed by the government’s ownership). What effect does that have on us? It would be foolish to say none, but to be honest it’s not that big of a deal. The Nightmare Scenario is that China dumps all of it’s T-Bills, causing the dollar and the US financial system to collapse and crippling the government’s ability to borrow. Both the cause and effects here are incredibly unlikely. Consider the following:

1. As argued above, so long as China wants to run a trade surplus with respect to the US, they must continue to accumulate our financial assets;

2. If they decide to no longer run a surplus or to reduce it, then this would create an boost to our domestic demand since we would no longer be buying from them (and could perhaps be selling more to them);

3. If China dumped its US debt, then it would either be because they wanted to save less or in a different from. But no other financial asset offers the safety of T-Bills–to what, realistically, would they move? The US has the globe’s largest single economy united under a single policy regime. And if they decided they wanted to cash in T-Bills and spend the proceeds, almost all of this money would therefore come back to the US in the form of exports–hardly a bad thing.

4. At the end of the day and in a worst case scenario, the US has the ultimate trump card: the legal authority to print little pieces of paper with pictures of presidents on them (and no, this is not inflationary–a bit more on this below, but it really needs a whole entry by itself).

The bottom line is that we are hardly facing a doomsday scenario, at least not because of the accumulation of debt in China. The fact that we don’t make anything over here and that all the decent factory jobs that middle-class Americans used to have are gone is a much bigger problem, but no one seems to be talking about that.

US Bankruptcy???
To understand the role of the government, you need to know how the economy works in general. Explaining that (and then the financial crisis) was my reason for starting this blog in the first place. For those who are interested, I assembled all the relevant posts into a single document:

For present purposes, the important point is this: the market system cannot consistently generate sufficient demand to hire all those willing to work. There are a number of reasons why this is true, but just think of it in productivity terms. Technology has made it possible to satiate most consumer demands pretty quickly. These two posts are relevant here:

Just imagine for sake of argument that productivity were so high that it required only one person to produce and deliver all the goods and services demanded in the US. No one else would have a job (nor would that person, actually, since the others wouldn’t have income to pay her). The economy absolutely needs a sector that creates demand without regard for profit. That’s the government. Without their employment of soldiers, sailors, airmen, marines, librarians, teachers, firemen, policemen, etc., the economy would be much smaller, stagnating, and with high unemployment–something along the lines of the depths of the Great Depression. Despite our ability to produce goods and services on a scale the likes of which our planet has never before seen, we would not do so. Since the early 20th century, the economic problem has not been figuring out how to create stuff, but how to generate the income that makes that creation profitable. That’s what the New Deal started and WWII finished. The tremendous size of the government sector since 1945 has been the reason that recessions have been half as long as they were before the war started.

Of course, saying that the government sector is key to our economic prosperity does not mean that we need it to be in deficit. But, in fact, we do, unless we want to slowly drain purchasing power from the private sector. Think about this. Say there were no government and no foreign countries. All economic activity in the US would take place domestically and be carried out by private citizens (firms and households). As a group, they would earn what they spent. If private citizens spent $1000, that would also be (because someone else is standing on the other side of the cash register) what they earned. It is logically impossible for them, as a group, to spend more or less than what they earned–the values must be identical because it’s really double-entry bookkeeping. Every transaction that takes place is both spending (for the person buying something) and income (for the person selling something).

Now imagine that they create a government. It now becomes possible for each sector (private and government) to spend more than they earned or earn more than they spent. For example, say over its first year in existence, the government takes in $100 in tax revenues but doesn’t spend any of the cash. You might have something like this:

Government Budget Surplus and Private Sector Deficit

Private Government Total
Income $1000 $100 $1100
Spending $1100 $0 $1100
Balance -$100 +$100 $0

In this case, the private sector spent $1000 on the goods and services it created (which is what created the $1000 in income for them), plus they spent $100 for taxes. The government, meanwhile, earned $100 in income (via taxes), but spent nothing. The government budget is thus is surplus, while the private sector has gone into debt–by the exact same amount, of course. It is impossible for it to work out any other way. The balances must add to zero because, as the last column indicates, total spending must equal total income in a closed system. And with the government in surplus, the private sector goes into debt.

Government Budget Deficit and Private Sector Surplus

Private Government Total
Income $1100 $0 $1100
Spending $1000 $100 $1100
Balance +$100 -$100 $0

Now look what happens when the government is in deficit: the private sector gets a surplus. In this scenario, the government has collected no taxes, but spent $100 on goods and services produced by the private sector. This creates enough income for the private sector for them to actually save money rather than go into debt.

And here is a balanced budget:

Balanced Budgets for All

Private Government Total
Income $1100 $100 $1100
Spending $1100 $100 $1100
Balance $0 $0 $0

While the private sector is not going into debt, they also cannot accumulate any savings (this does not mean some individuals are not saving, but net it has to be zero). The only thing that can change the above scenario is if we add a foreign sector. If the nation can run a trade surplus (i.e., foreigners run a deficit), then either or both the private and government sectors can earn more than it saves. With a trade deficit (i.e., foreigners run a surplus), the opposite is true. This is one of the reasons Japan has had such high savings rates–that’s our money, from importing Japanese goods and services!

What the above means is this: government deficits create income for the private sector, while, all other things being equal, government surpluses drain it. And here’s the thing: while the private sector is burdened by the fact that if they have repeated deficits it creates rising levels of debt for them, lowering their ability to spend further, the government has no such constraint. The government need never pay off it’s debt. It’s not a household. It does not have a finite life span and may remain in debt forever. In fac, if it is to act as a stimulant to growth rather than a drag, it must. There is absolutely no reason for firms and households to subside the one sector of the economy that is allowed to tax and print money!!!

There are many other issues I’d like to address here but I’m afraid it’s getting too long and complicated. But hopefully this offers some perspective on what’s going on right now. The US debt with China is a function of our years of trade deficits with them, which have in turn been so large because China is actively purchasing our financial assets, preventing the yuan from appreciating. We have a large national debt, but a) it’s been larger (late 1940s and the 1950s witnessed very low unemployment and high GDP growth–both of which contribute to the reduction of debt) and b) there are many respected, developed economies ahead of us. And there is no indication that we have any desperate need to pay it down. In fact, if we did that, we would cripple a private sector already burdened by debt and cause a major resurgence in unemployment. The only thing scarier than talking about money and the debt is misunderstanding it.

EDIT: After rereading Randy Wray’s post (first link above), I wanted to repeat his conclusion:

We don’t need myths. We need more democracy, more understanding, and more transparency. We do need to constrain our leaders—but not through dysfunctional superstitions.

P.S. This sucker has taken all day to write and I really wanted to talk about much more. As much as I want to say it’s done now, let me address one more thing very quickly. Am I arguing above that all deficits are good? That the more spending, the better? No, the size should be a function of how much it takes to generate sufficient demand to employ all those willing to work. To some extent that’s easy to check. Right now, for example, it’s too small, because employment is well below full. Another stimulus is absolutely in order. And the great thing is that as unemployment falls, the budget will begin to return itself to balance (though not completely), but doing this justice would take doubling the length of this entry, at least–I’ll leave that for another time!

P.P.S. Here’s another post on the same subject by a fellow traveler:

Written by rommeldak

July 13, 2010 at 9:10 pm

Posted in Uncategorized