In Defense of Deficits
By James K. Galbraith
The Nation, 22 March 2010
The Simpson-Bowles Commission, just established by the president, will no doubt deliver an attack on Social Security and Medicare dressed up in the sanctimonious rhetoric of deficit reduction. (Back in his salad days, former Senator Alan Simpson was a regular schemer to cut Social Security.) The Obama spending freeze is another symbolic sacrifice to the deficit gods. Most observers believe neither will amount to much, and one can hope that they are right. But what would be the economic consequences if they did? The answer is that a big deficit-reduction program would destroy the economy, or what remains of it, two years into the Great Crisis.
For this reason, the deficit phobia of Wall Street, the press, some economists and practically all politicians is one of the deepest dangers that we face. It's not just the old and the sick who are threatened; we all are. To cut current deficits without first rebuilding the economic engine of the private credit system is a sure path to stagnation, to a double-dip recession--even to a second Great Depression. To focus obsessively on cutting future deficits is also a path that will obstruct, not assist, what we need to do to re-establish strong growth and high employment.
To put things crudely, there are two ways to get the increase in total spending that we call "economic growth." One way is for government to spend. The other is for banks to lend. Leaving aside short-term adjustments like increased net exports or financial innovation, that's basically all there is. Governments and banks are the two entities with the power to create something from nothing. If total spending power is to grow, one or the other of these two great financial motors--public deficits or private loans--has to be in action.
For ordinary people, public budget deficits, despite their bad reputation, are much better than private loans. Deficits put money in private pockets. Private households get more cash. They own that cash free and clear, and they can spend it as they like. If they wish, they can also convert it into interest-earning government bonds or they can repay their debts. This is called an increase in "net financial wealth." Ordinary people benefit, but there is nothing in it for banks.
And this, in the simplest terms, explains the deficit phobia of Wall Street, the corporate media and the right-wing economists. Bankers don't like budget deficits because they compete with bank loans as a source of growth. When a bank makes a loan, cash balances in private hands also go up. But now the cash is not owned free and clear. There is a contractual obligation to pay interest and to repay principal. If the enterprise defaults, there may be an asset left over--a house or factory or company--that will then become the property of the bank. It's easy to see why bankers love private credit but hate public deficits.
All of this should be painfully obvious, but it is deeply obscure. It is obscure because legions of Wall Streeters--led notably in our time by Peter Peterson and his front man, former comptroller general David Walker, and including the Robert Rubin wing of the Democratic Party and numerous "bipartisan" enterprises like the Concord Coalition and the Committee for a Responsible Federal Budget--have labored mightily to confuse the issues. These spirits never uttered a single word of warning about the financial crisis, which originated on Wall Street under the noses of their bag men. But they constantly warn, quite falsely, that the government is a "super subprime" "Ponzi scheme," which it is not.
We also hear, from the same people, about the impending "bankruptcy" of Social Security, Medicare--even the United States itself. Or of the burden that public debts will "impose on our grandchildren." Or about "unfunded liabilities" supposedly facing us all. All of this forms part of one of the great misinformation campaigns of all time.
The misinformation is rooted in what many consider to be plain common sense. It may seem like homely wisdom, especially, to say that "just like the family, the government can't live beyond its means." But it's not. In these matters the public and private sectors differ on a very basic point. Your family needs income in order to pay its debts. Your government does not.
Private borrowers can and do default. They go bankrupt (a protection civilized societies afford them instead of debtors' prisons). Or if they have a mortgage, in most states they can simply walk away from their house if they can no longer continue to make payments on it.
With government, the risk of nonpayment does not exist. Government spends money (and pays interest) simply by typing numbers into a computer. Unlike private debtors, government does not need to have cash on hand. As the inspired amateur economist Warren Mosler likes to say, the person who writes Social Security checks at the Treasury does not have the phone number of the tax collector at the IRS. If you choose to pay taxes in cash, the government will give you a receipt--and shred the bills. Since it is the source of money, government can't run out.
It's true that government can spend imprudently. Too much spending, net of taxes, may lead to inflation, often via currency depreciation--though with the world in recession, that's not an immediate risk. Wasteful spending--on unnecessary military adventures, say--burns real resources. But no government can ever be forced to default on debts in a currency it controls. Public defaults happen only when governments don't control the currency in which they owe debts--as Argentina owed dollars or as Greece now (it hasn't defaulted yet) owes euros. But for true sovereigns, bankruptcy is an irrelevant concept. When Obama says, even offhand, that the United States is "out of money," he's talking nonsense--dangerous nonsense. One wonders if he believes it.
Nor is public debt a burden on future generations. It does not have to be repaid, and in practice it will never be repaid. Personal debts are generally settled during the lifetime of the debtor or at death, because one person cannot easily encumber another. But public debt does not ever have to be repaid. Governments do not die--except in war or revolution, and when that happens, their debts are generally moot anyway.
So the public debt simply increases from one year to the next. In the entire history of the United States it has done so, with budget deficits and increased public debt on all but about six very short occasions--with each surplus followed by a recession. Far from being a burden, these debts are the foundation of economic growth. Bonds owed by the government yield net income to the private sector, unlike all purely private debts, which merely transfer income from one part of the private sector to another.
Nor is that interest a solvency threat. A recent projection from the Center on Budget and Policy Priorities, based on Congressional Budget Office assumptions, has public-debt interest payments rising to 15 percent of GDP by 2050, with total debt to GDP at 300 percent. But that can't happen. If the interest were paid to people who then spent it on goods and services and job creation, it would be just like other public spending. Interest payments so enormous would affect the economy much like the mobilization for World War II. Long before you even got close to those scary ratios, you'd get full employment and rising inflation--pushing up GDP and, in turn, stabilizing the debt-to-GDP ratio. Or the Federal Reserve would stabilize the interest payouts, simply by keeping short-term interest rates (which it controls) very low.
What about indebtedness to foreigners? True, foreigners do us a favor by buying our bonds. To acquire them, China must export goods to us, not offset by equivalent imports. That is a cost to China. It's a cost Beijing is prepared to pay, for its own reasons: export industries promote learning, technology transfer and product quality improvement, and they provide jobs to migrants from the countryside. But that's China's business.
For China, the bonds themselves are a sterile hoard. There is almost nothing that Beijing can do with them. China already imports all the commodities and machinery and aircraft it can use--if it wanted more, it would buy them now. So unless China changes its export policy, its stock of T bonds will just go on growing. And we will pay interest on it, not with real effort but by typing numbers into computers. There is no burden associated with this, not now and not later. (If the Chinese hoard the interest, they also don't help much with job creation here. So the fact that we're buying a lot of goods from China simply means we have to be more imaginative, and bolder, if we want to create all the jobs we need.) Finally, could China dump its dollars? In principle it could, substituting Greek bonds for American and overpriced euros for cheap dollars. On brief reflection, no Beijing bureaucrat is likely to think this a smart move.
What is true of government as a whole is also true of particular programs. Social Security and Medicare are government programs; they cannot go bankrupt, and they cannot fail to meet their obligations unless Congress decides--say on the recommendation of the Simpson-Bowles Commission--to cut the benefits they provide. The exercise of linking future benefits and projected payroll tax revenues is an accounting farce, done for political reasons. That farce was started by FDR as a way of protecting Social Security from cuts. But it has become a way of creating needless anxiety about these programs and of precluding sensible reforms, like expanding Medicare to those 55 and older, or even to the whole population.
Social Security and Medicare are transfer programs. What they do, mainly, is move resources around within our society at a given time. The principal transfer is not from the young to the old, since even without Social Security the old would still be around and someone would have to support them. Rather, Social Security pools resources, so that the work of the young collectively supports the senior population. The effective transfer is from parents who have children who would otherwise support them (a fairly rare thing), to seniors who don't. And it is from workers who do not have parents to support, to workers who would otherwise have to support their parents. In both cases this burden sharing is fair, progressive and sustainable. There is a healthcare cost problem, as everyone knows, but that's not a Medicare problem. It should not be solved by cutting back on healthcare for the old. Social Security and Medicare also replace private insurance with cheap and efficient public administration. This is another reason these programs are the hated targets, decade after decade, of the worst predators on Wall Street.
Public deficits and private lending are reciprocal. Increased private lending generates new tax revenue and smaller deficits; that's what happened in the 1990s. A credit collapse kills the tax base and generates more spending; that's what's happening now, and our big deficits are the accounting counterpart of the massive decline, last year, in private bank loans. The only choice is what kind of deficit to run--useful deficits that rebuild the country, as in the New Deal, or useless ones, with millions kept unnecessarily on unemployment insurance when they could instead be given jobs.
If we could revive private lending, should we do it? Well, yes, up to a point there is good reason to have a robust private lending sector. Government is by nature centralized and policy driven. It works by law and regulation. Decentralized and competitive private banks have much more flexibility. A good banking system, run by capable people with good business judgment who know their clients, is good for the economy. The fact that you have to pay interest on a loan is also an important motivator of investment over consumption.
But right now, we don't have functional big banks. We have a cartel run by an incompetent plutocracy, with its long fingers deep in the pockets of the state. For functional credit to return, we'll have to reduce the unpayable private debts now outstanding, to restore private incomes (meaning: create jobs) and collateral (meaning: home values), and we'll have to restructure the big banks. We need to break them up, shrink the financial sector overall, expose and prosecute frauds, and create incentives for profitable lending in energy conservation, infrastructure and other sectors. Or we could create a new parallel banking system, as was done in the New Deal with the Reconstruction Finance Corporation and its spinoffs, including the Home Owners' Loan Corporation and later Fannie Mae and Freddie Mac.
Either way, until we have effective financial reform, public budget deficits are the only way toward economic growth. You don't have to like budget deficits to realize that we must have them, on whatever scale necessary to restore growth and jobs. And we will need them not just now but for a long while, until we've shaped a strategic program for investment, energy and the environment, financed in part by a reformed, restored and disciplined financial sector.
It's possible, of course, that all the deficit hysteria is intended to divert attention from the dysfunctions of private banking, and so to help thwart calls for financial reform. Is that giving them too much credit? Maybe. Maybe not.
About James K. Galbraith
James K. Galbraith is the author of The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too. He teaches at the LBJ School of Public Affairs at the University of Texas and is a senior scholar at the Levy Economics Institute.