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Friday, March 4, 2011

On Deficit Spending, Money Creation and Growing Economies


Almost everyone agrees with the common sense belief that deficit spending is inherently wrong, that since individuals and families need to balance their budgets, so must the federal government. The common sense definition of deficit spending that people often give is "spending more money than you take in, spending money you don't have."[1]

I'd like to explore this common sense definition and show that it has some unexpected consequences for growing economies.

Imagine an economic system in which no one (including individuals, business, banks, and governments) spent more money than they took in, or spent any money they didn't have. Assume for the moment that money is just paper currency, ordinary coins, or data in bank accounts, but not based on gold or silver, or any physical product of the economy -- I'll consider those options separately below.

In this hypothetical economy, the total amount of money in circulation would never increase, and if it were never destroyed then there would only be a constant amount of money in the economy. [2]

Now suppose the economy is growing, producing more goods and services each year, with strong employment so there is demand for the goods and services being produced. If the money supply is constant, then the price of goods and services would be forced to continually decrease as the economy grows. There would be continual deflation, which would be just as harmful as inflation. Indeed, deflation caused severe hardship during the Great Depression. Deflation would act as a brake, halting economic growth and causing recessions.[3]

To avoid deflation in a growing economy, somehow the money supply must increase at a pace matching the economy's growth in goods and services, and growth in employment and demand for goods and services. Increasing the money supply at this pace will also avoid inflation.

For the money supply to increase, some entity must create and spend money it did not take in, or already have. This means that some entity must be a "money source" and engage in deficit spending, according to the commonsense definition of "deficit spending" that people normally use.

Therefore, using the commonsense notion of deficit spending, some amount of deficit spending is necessary in growing economies, to avoid deflation. We should not go beyond that amount, to avoid inflation.

At this point, it's important to note that the commonsense definition of deficit spending ("spending more money than you take in, spending money you don't have") does not necessarily imply borrowing money. An entity can spend money it doesn't already have either by creating new money, or by borrowing money. This logic does not imply any particular system for money creation. [4, 5]

Also, this logic does not show that money creation or deficit spending causes economic growth. It only shows that some form of money creation is necessary in economies that are already growing, to avoid deflation.

So, this logic is not a Keynesian argument, nor does it imply Keynesian stimulus spending. Whether or not a particular stimulus program is worthwhile needs to be judged on its own merits, or lack thereof. This is a topic discussed in other papers. Here, I'll simply say that if we are going to invest stimulus money then it should be used for proven, efficient, large-scale energy production to generate both short-term and long-term self-sustaining jobs, promote economic growth & energy independence. [6]

There need to be mechanisms that enable the right amount of money creation or borrowing to match the growth of the economy, and avoid both deflation and inflation. These mechanisms should avoid imposing higher taxes and interest rates on the public, avoid re-distributing wealth, and avoid imposing unsustainable obligations on future generations. A discussion of such mechanisms is also a topic for a future paper.

This logic does not involve creating wealth out of thin air. It just shows there must be a source of new money (money that did not previously exist) to avoid deflation. When this new money is created, it should match new wealth (e.g. new products) being created by the growth of the economy. [7]

This logic would not apply if the money supply were based on products created by the economy, especially products that inherently sustain or derive from economic growth. This is also a topic for a future paper.

Another commonsense idea is that the money supply should be based on gold, or other 'precious metals'. Eichengreen (2011) discusses issues related to the gold standard, as well as additional issues related to monetary systems and deficit spending. There is no geological guarantee that the supply of gold can increase in proportion to economic growth, to avoid either inflation or deflation within the economy. Indeed, the total value of all gold ever mined on Earth is about $9 trillion, at the current price of gold - not enough to support the world economy as money, or even pay back the US federal debt. The supply of silver is also too limited to support the US or world economy as money, at current silver prices.

A third commonsense idea is that the US Constitution should have a Balanced Budget Amendment, preventing any future deficit spending by the government. Let's assume the legal and constitutional problems (Schuck, 2011) associated with this could be resolved and imagine what would happen if it were actually in place. Imagine also there were no ways to avoid it, e.g. no way for the Federal Reserve to loan or spend money it didn't already have. Though there might be some short-term economic growth due to strengthening the dollar, the above discussion shows  the eventual result would be deflation that would halt economic growth within the US. To continue growing past that point, the US economy would be forced to rely on currencies of other nations, which themselves might engage in deficit spending. This would jeopardize US national security and economic growth.

Though this paper shows some form of money creation is necessary in growing economies, the US economy is not growing at present. The key question, how can we restore growth to the US economy (including growth in jobs), is also a topic for discussion in a separate paper.

This logic would itself be considered common sense by many economists. Even so, it is important for the public and policy makers to understand that starting from a common sense definition of deficit spending, we are logically forced to conclude it is necessary in growing economies. In  efforts to avoid or minimize potential negative consequences of deficit spending, we need to avoid changes that would prevent money creation and hinder economic growth.

REFERENCES

Eichengreen, Barry (2011) A Critique of Pure Gold. The National Interest, August 21, 2011.

Schuck, Peter H. (2011)  The Balanced Budget Amendment's Fatal Flaw. The Wall Street Journal, July 22, 2011.

NOTES

[1] Wikipedia gives a more standard, technical definition:  "deficit spending is the amount by which a government, private company, or individual's spending exceeds income over a particular period of time, also called simply 'deficit,' or 'budget deficit,' the opposite of budget surplus."

[2] Money creation is also possible via 'multiple lending' by 'fractional reserve' banks. This effectively increases the money supply by 1/r, where r is the reserve ratio banks are required to maintain for withdrawals. This cannot increase the money supply above the theoretical limit M/r, where M is the amount of money originally present. Thus even with multiple lending, the money supply is bounded by a constant, M/r, and deflation will eventually occur in a growing economy. If multiple lending were the only mechanism to create money, then there would eventually need to be reductions in the reserve ratio to avoid deflation in a growing economy, which would make banks increasingly less stable. Also, multiple lending is itself a form of deficit spending: When banks loan money, the  people who borrow money are incurring debt and using money they did not already have and will need to pay back, with interest. Hence the use of multiple lending to effectively increase the money supply does not disprove my logic that some form of commonsense deficit spending is necessary to avoid deflation in growing economies.

[3] Deflation tends to halt economic growth because: Buyers have an incentive to delay purchases since as prices go down, their money will be able to purchase more later;  Employers need to reduce wages when they get less money for their products; Employers have an incentive to delay hiring since wages can be expected to decrease; etc.

[4] In 1913, Congress delegated the ability to create new money to the Federal Reserve banking system. The US federal government may borrow money from the Federal Reserve, or from foreign, state or local governments.

[5] 'Private money' systems are possible that allow distributed money creation within an economy.

[6] Building Hoover Dam did that in the 1930's, and is still producing a return on investment, in hydroelectric energy. Just investing in infrastructure (roads, bridges) does not create self-sustaining jobs. The 2009 stimulus funds should have gone into a major expansion of oil, coal, natural gas, and nuclear power in the US, not just into inefficient green energy and transportation infrastructure (which takes energy to maintain and repair, but does not directly create energy).

[7] Strictly speaking, money is not wealth: money only represents wealth in commercial  transactions. As long ago as 1776, in The Wealth of Nations, Adam Smith clearly distinguished money from wealth, describing wealth as "the annual produce of the land and labour of the society"'.