Almost everyone agrees with the commonsense belief that deficit spending is inherently wrong, and that since individuals and families need to balance their budgets then so must the federal government. The commonsense definition that people often give is “deficit spending is spending more money than you take in, spending money you don't have.” [Note 1]
I'd like to explore this commonsense definition and show that adhering to it can have some very negative consequences for a growing economy.
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 that 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 can be in other economic situations. For example, 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 matching growth in employment and demand for goods and services. Increasing the money supply at just this pace will also avoid inflation.
For the money supply to increase, at least one 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 was given above, which 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 of prices for goods and services.
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. Also, this logic does not imply any particular system for money creation. [4, 5]
And 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. Here, I'll simply suggest that if we are going to invest stimulus money, then a priority should be to use it for proven, efficient, large-scale energy production, to indirectly generate both short-term and long-term self-sustaining jobs, and to promote economic growth and 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 would also be 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 to avoid deflation in a growing economy. 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, and which are not limited by the natural resources of Earth. An example of such a product would be solar power collected by satellites, not limited or affected by weather in Earth’s atmosphere. Basing the money supply on such solar power would also be a topic for a future paper.
An erroneous commonsense idea is that the money supply should be based on gold, or other ‘precious metals.’ Eichengreen (2011) discussed 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 $7.5 trillion, at the current price of gold - not enough to support the world economy as money or even to pay back the US national debt, which is approaching $37 trillion. The supply of silver is also too limited to support the US or world economy as money, at current silver prices.
Another unworkable commonsense idea is that the US Constitution should have a Balanced Budget Amendment, preventing any future deficit spending by the government.
Let us assume that 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 that there were no ways to avoid it, e.g., no way for the Federal Reserve to create, loan or spend money that it did not already have. Though there might be some short-term economic growth as a result of strengthening the dollar, the above discussion shows the eventual result of a Balanced Budget Amendment would be deflation that would halt economic growth within the United States. To continue growing past that point, the US economy would be forced to rely on the currencies of other nations, which themselves might engage in deficit spending. This would jeopardize US national security and economic growth. It could also strengthen the economies of other nations that engage in deficit spending and make them geopolitically stronger than the United States. At present the U.S. dollar is the most widely used currency for international trade, which strengthens the United States in global markets.
The logic presented in this paper would probably be considered obvious and common sense by many economists. Even so, it is important for the public and policy makers to understand that starting from a commonsense definition of deficit spending, we are logically forced to conclude that deficit spending is necessary in growing economies. In efforts to avoid or minimize potential negative consequences of deficit spending, we also need to avoid changes that would prevent money creation and hinder economic growth.
REFERENCES
Schuck, Peter H. (2011) The Balanced Budget Amendment's Fatal Flaw. The Wall Street Journal, July 22, 2011.
[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 that 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] In effect, Bitcoin is a system for betting about the future value of a bitcoin in terms of other currencies like the dollar. Indirectly, purchasing a bitcoin is a bet about potential future inflation or deflation of government-issued currencies like the dollar, vs. potential future inflation or deflation of Bitcoin.
[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). In a recent paper (3), I discuss the best fuels for the future and give reasons why thorium and synthetic carbon-based fuels will be humanity’s best fuels for the future, along with solar power collected at the Moon and with geostationary solar power satellites.
[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”.
