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Debt and Deficit in a Nutshell: The Video!

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My friend, Tschäff Reisberg, made a flash video of my blog post on the debt and the deficit and posted it to You Tube:

Thanks, Tschäff! Very nicely done!

Written by rommeldak

November 14, 2010 at 11:33 am

Posted in Uncategorized

World’s Simplest Explanation of the Debt and the Deficit

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(and why cutting spending right now would be an unmitigated disaster)

There may be no single economic concept that is more poorly understood by the lay public and most politicians (both varieties) than the federal government’s budget. I suspect that some of that is willful ignorance with an ulterior motive, but the vast majority is simply and solely because it has never been explained to them. They assume it’s like their personal or business budget. It’s not. It’s fundamentally different and lessons drawn from one cannot necessarily be applied to the other. I’ll try to make this as short as possible but, dammit, it’s sort of complicated! You can’t truly understand it, however, without this background–and you need to understand it.


First off, you’ll need a basic understanding of the operation of the macroeconomy as a whole. Think of it this way. Say that there are eleven people in our economy playing the following roles:

1. Adam: worker
2. Betsy: worker
3. Charlie: worker
4. Danielle: worker
5. Eva: worker
6. Fred: worker
7. George: worker
8. Hannah: worker
9. Isaac: worker
10. John: worker
11. Kate: entrepreneur

There is no government and no foreign sector. Kate is the only potential employer in this world, and she has a factory that makes all the goods and services that everyone else demands. Kate’s factory can produce sufficient output for all ten workers (for simplicity I’ll ignore the fact that Kate needs to consume, too), but by employing only eight of them. Kate is not a charity–she has a family to feed, as well–so she won’t hire all ten just to be nice. She only needs Adam through Hannah to make goods and services for Adam through John, and therefore that’s all she’ll hire. But wait, that’s not quite right, is it? Because if Isaac and John don’t have job (recall that Kate is the only employer), then there is no point is making goods they can’t afford to purchase. Hence, Kate doesn’t even hire eight people. For sake of argument, let’s say that rolling back production to seven people creates an equilibrium in which Kate can hire Adam through George and they only create output for Adam through George.

Now we have the following:

1. Adam: working for Kate
2. Betsy: working for Kate
3. Charlie: working for Kate
4. Danielle: working for Kate
5. Eva: working for Kate
6. Fred: working for Kate
7. George: working for Kate
8. Hannah: unemployed
9. Isaac: unemployed
10. John: unemployed
11. Kate: earning profits associated with sales to seven workers

In the smallest nutshell possible, this is how the macroeconomy works. It is absolutely vital to understand this in thinking about the federal (though not state and local–they DO operate like your personal budget) government budgets.

Put in the front of your mind a fundamental fact about the above situation: we have the physical capacity to produce output for Hannah, Isaac, and John, but because we can do so relatively easily (i.e., without their help), they have to go without. Not only is this a really crappy deal for Hannah, Isaac, and John, but Adam through George are probably somehow supporting them (officially or unofficially) and Kate would love to be earning the extra profits associated with sales to those three. EVERYONE is made worse off by this situation. The underlying problem is that as productivity increases, so it becomes more and more difficult for the profit motive alone to generate full employment in a macroeconomy.

But note how incredibly easy this is to solve in a way that raises everyone’s welfare:

1. Adam: working for Kate
2. Betsy: working for Kate
3. Charlie: working for Kate
4. Danielle: working for Kate
5. Eva: working for Kate
6. Fred: working for Kate
7. George: working for Kate
8. Hannah: working for Kate
9. Isaac: soldier (government job)
10. John: police officer (government job)
11. Kate: earning profits associated with sales to ten workers

Let’s create a government sector and have them make Isaac a soldier and John a police officer. They are each paid a salary sufficient to buy what Kate is selling, and this leads Kate to hire Hannah (since she now needs to produce more output) and everyone is happy: Adam through George don’t have to support three unemployed people, Hannah, Isaac, and John can now share in the output that could already be produced for them, and Kate earns higher profits. In addition, not only did Adam through George have to give up absolutely nothing in terms of what they had been buying from Kate, but they how have protection from domestic and international aggression. EVERYONE is better off.

This is the essential role of the federal government in a mature capitalist economy. Without the government supplementing demand, the system breaks down and despite our ability to produce goods and services for everyone, we don’t. There will also be cyclical highs and lows (we are experiencing the latter at the moment, in case you had not noticed!), but in general we face the problems outlined above and this is something the private sector cannot solve on its own.


Whence comes the money the government uses to pay Isaac and John?

Option 1: Taxes

They could tax those originally working (Adam through George), but then that means they won’t be able to buy the same volume of Kate’s products as they were before. There is no logical reason that Adam through George should have to settle for less, so that’s not a good idea. All we would be doing is changing who had the income generated in the macroeconomy (i.e., taking it from Adam through George and giving it to Isaac and John–recall that Hannah’s salary is created by private sector sales to Isaac and John). We need MORE income, not a redistribution. Again, there is zero reason why Adam through George need give anything up.

Option 2: Borrowing

The government could borrow money from those originally working (Adam through George) and use that to pay Isaac and John (Hannah gets paid from private-sector profits arising from sales of Kate’s products to Isaac and John). This assumes that Adam through George are earning enough to both buy from Kate and save some money, but if so, then this might be a useful thing to do. It would probably give Adam through George a relatively low rate of return, but a very safe investment. In fact, when they first introduced US government t-bills (during WWI), they were TOO popular!

However, our goal is not to give Adam through George an attractive means of saving, but to create jobs for Isaac and John (directly) and Hannah (indirectly). In addition, there is absolutely no reason to expect that the volume the government could borrow would equal what they need to pay the salaries of Isaac and John. It depends entirely on how much savings currently exist. Furthermore, people are least likely to be willing to tie up savings in such instruments precisely when we would be most in need of selling them: during recessions. And they would have less income to save, too. Furthermore, we don’t want people to become fixated on the idea that if the government borrowed, this means they have to pay it all back. Of course, each individual debt must be honored, but a) it need never be reduced to zero and b) so long as the debt is owed in dollars (as it is) then we can never go bankrupt. In fact, one of my colleagues actually has a page where he has promised $100 million to pay down the debt if anyone can prove that the US can go bankrupt:

That’s a safe bet for him. It can’t happen.

Option 3: Printing Money

But, frankly, the most obvious and straightforward thing to do is this: print the money to pay their salaries. People typically react to this with shock, crying out, “But that will cause inflation!” No it doesn’t (for a more in-depth treatment, read my posts on inflation below).

The short story on inflation is this: printing more money can be inflation if no more goods and services are produced (but even then it doesn’t have to–see below). But remember that the whole point of raising the money supply here is to raise the volume of goods and services produced. We pay Isaac and John enough to make the production of goods from Kate’s factory profitable to her (and so that she hires Hannah, too). Hence, the level of output rises just as much as the volume of the money supply, and there is no inflation. Contrast that with the situation in a small, developing nation. Perhaps our productive capacity is such that we simply can’t produce enough for all ten workers, only Adam through George. In that case, giving jobs to Isaac and John just causes inflation–more money, but no more goods than before. That’s not the case in the US, however.

Technically, we cannot choose to simply print money to fund government spending in the US–but, de facto, we can if we use Option 2, and the Federal Reserve buys the debt (they are already the #1 single owner of federal government debt). Since they will pay with brand new dollar bills, the new spending is created with new cash. This creates new demand without draining it from somewhere else in the macroeconomy or creating the illusion of a burden on future generations (actually, the illusion might still be there, but I suspect that people are less worried about us owing the Fed money than the Chinese!).


I am horribly, horribly tempted to write more (in fact, I did, but I’m cutting it), but I really wanted to make this as short as possible while getting the main point across. So, I’ll stop here. My main points are these:

1) It is critical that the government generate demand in the macroeconomy if we are to reach full employment–and it doesn’t cost anyone anything for them to do so since we are starting at less-than-full capacity. If we don’t do this, then we are–I don’t know how else to say it–royally screwed. THIS is the key problem.

2) In a technical sense, we don’t need to “finance” any of the spending. In other words, it’s not necessary for us to find someone with extra cash to loan us. We can simply print it (or have the Fed buy the debt), and in fact that makes the most sense since our goal is to expand demand, not rearrange it.

3) Since the debt is issued in our own currency (Greek debt was not, incidentally), we cannot possibly go bankrupt. That concept does not make sense in this context.

A private budget is fundamentally different from the federal one. Going into debt with the former represents an attempt to purchase something we could not otherwise afford. The goal of going into debt at the federal level represents jump-starting what we could have already done in the first place if, ironically, productivity had been lower and Kate had needed all ten workers.

Unfortunately, we all have a gut feeling that debt is bad and surplus is good, but that’s because we are transferring logic from our own personal lives to the federal government. It simply doesn’t apply (it is, as Paul Samuelson once said, a myth that is useful only insofar as it imposes a cost on government officials who might have a little too much fun spending money). Furthermore, if we not only do not spend more money right now, but begin to cut back, then we are doomed to a Japan-like, decade-long period of recession. To be honest, I think that’s where we are headed. Not only do the Republicans, now in greater power than before, believe that is what we need to do, but Obama only disagrees with them in degree, not in principle. Remember how the Great Depression ended? The massive government spending from WWII. Only under such circumstances were we able to make people forget about what they think of as “fiscal responsibility” and focus instead on (inadvertently, of course) economic responsibility.

I have a funny feeling the Japanese aren’t going to save us this time.

P.S. We owe China so much money because of the trade deficit, not the budget deficit. See the discussions of the debt and deficit below.

Written by rommeldak

November 7, 2010 at 1:59 pm

Posted in Uncategorized