Post-Keynesian Observations

Understanding the Macroeconomy

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

2 Responses

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  1. correction

    there is another are of economic analysis where scientific >>>> there is another area of economic analysis where scientific


    July 14, 2010 at 9:03 am

  2. Thank you–fixed!


    July 14, 2010 at 10:00 am

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