The Return of the Hawks

Part 1: A slightly wonky take as the deficit hawks begin to circle

January 1, 2021: What the Biden Administration Will Face

The new Administration comes into office in twenty days having to deal with the pandemic and damage it inflicted upon the economy. There is a need for the government to enact another round of fiscal stimulus, but it appears such attempts will be attacked by the deficit hawks, the fiscal conservatives whose raison d’tre is resistance to government budget deficits. In the Senate debate this week on a bill to authorize additional direct payments for Covid relief, Senator Ron Johnson (R-WI), reprised the call of the hawks, saying such payments would in effect mean “mortgaging our children’s future”. The Senator was referring to the borrowing the government must do to balance its budget in the face of shortfalls (deficits) between revenue and spending. The irony of hawks like Johnson beginning to circle now is that, during the Trump Administration, the Republicans grew the deficit with a large tax cut bill and increased defense spending. The already-large budget gap was exacerbated by the various relief measures enacted earlier in 2020 to bolster an economy shrunk by actions (lockdowns) to mitigate the spread of the coronavirus .

The hawks’ argument consists of fear-mongering cloaked in reasonable-sounding rhetoric. Their talking points are phrases such as the government is “living off its credit card and leaving our children and grand-children to pay the bill”, or “none of us could run our households if we were constantly in debt”. To most people, the word “debt” is itself anxiety-inducing : being “in debt” is viewed as a negative circumstance. This all makes sense… Or does it?

Let’s consider the idea of government deficits and debt in more detail.

The Deficit and the National Debt

As pointed out, the deficit is the amount of money the Federal government spends that exceeds the amount it collects (through taxes, for instance). The accumulated sum of these deficits is the national debt (currently at $27 trillion, having risen $7 trillion since Trump took office). From the inception of the Republic in 1790, the US has, except for a brief period in the mid-1830’s, continually carried a debt burden.

Suppose we invert our thinking and look at the deficit not as a straight-forward budgetary shortfall. Instead, we could see it as the government using its spending to inject money into the economy. When the government spends money on defense, a large part of that money goes to the companies that manufacture the planes and ships, and who are paying for labor and materials. When the government invests in infrastructure, it directs funds to states to build highways and bridges, the states in turn hiring private contractors who spend money on labor and materials. Money paid to government employees and contractors, or used for transfer payments like Social Security and various safety net programs, and even interest on the debt itself- all these put money into the hands of people and businesses who put it back into the economy via spending or investing. Since the government collects taxes on some of that money- for example, income and payroll taxes paid by wage earners- it in fact recovers some of the money it spends.

What if the government, instead of a deficit, runs a budget surplus, a circumstance where government revenues exceed outlays? This happened in the last four years of the Clinton administration. Again, let’s view the situation through the inverse lens: if a deficit means the government is putting money into the economy, a surplus means it is extracting money from the economy. This may not be a desirable outcome, as it deprives the private sector of the funds it would use to invest in and grow the economy.

Similar to surpluses, a balanced budget where revenues and expenditures are equal, could lead to adverse economic consequences. Worst-case would be a Balanced-Budget Amendment to the Constitution which would constrain the government’s use of its fiscal tools. This is a pet project of libertarian right, whose essential ideology is to oppose a large central government and the taxes needed to support it. The proponent’s of a balanced budget view it as a way to both limit government spending, especially social welfare programs such as Social Security and Medicare, and to reduce taxes. In effect, the government would be constrained from using its fiscal power and authority to sustain economic growth.

Historically, spikes in spending occurred in times of crisis. In the 20th Century, two World Wars, the New Deal programs of the Great Depression, and the war in Vietnam resulted in higher levels of deficit spending. Since 2000, the wars in Afghanistan and Iraq, the Great Recession of 2007-2009, and the current pandemic triggered additional increases in spending and borrowing. If the government were forced to balance its budget, its alternatives to protect the nation during similar crises would be limited to drastic tax increases or whole-sale cuts in spending, neither of which would be popular.

One more significant point on deficits and debt: In the bookkeeper’s balance sheet terms, money owed is a liability; being owed money is an asset. The financial instrument the US Treasury uses to borrow money is the interest-bearing bond*. The Treasury sells as many of these securities as needed to raise the funds required to balance the budget. For those who hold these various bills, notes, or bonds, they are assets. They can be bought and sold on bond markets. They earn interest for the holder. Backed by the “full faith and credit of the United States”, they are low-risk investments.

Fact: GDP has quadrupled over the last 50 years. The Federal government ran deficit budgets 46 of those 50 years. 

A Word on Debt

Let’s return to the scary word, debt. It is intimidating because, in financial terms, it means an obligation to pay. But debt is not necessarily a negative. For instance, if you purchase a home, a house or a condominium, unless you have enough cash on hand to pay full price, you obtain a mortgage, a loan from a bank or mortgage company. Spreading the debt over time allows you to gain ownership of an asset in a manageable fashion. As long as you are able to maintain the monthly payments, debt is positive. In the best case scenario, your home would appreciate in value over the term of the mortgage so that its value exceeds the total you paid including interest.

Debt is also a way to ‘create’ money. A commercial real estate developer might purchase property with borrowed funds, improve it, and sell it at a profit. In macro economic terms, that profit is an addition to the money supply- a creation.

I made an even simpler analogy in 2013:

My friend Jack wants me to loan him $100. He claims he will pay me back the $100 with $20 in interest. Problem is, I don't have the hundred bucks. However, my sister will lend me the $100 and will do so for an interest charge of only 5 dollars. So, if I go $100 in debt, I have the opportunity to make $15. Not bad.

- "The Balanced Budget Amendment Talking Point Blues"

Inflation: Fiscal Policy and Monetary Policy

For deficit hawks, one of the bogeymen of the deficit is inflation. Since deficit spending increases the money supply, the thinking goes, it creates upward pressure on prices and so is ultimately inflationary. Economists are divided on this issue, some taking the position that deficits fuel demand and thus economic growth. Others adhere to the view that government borrowing has a “crowding-out” effect: money used to purchase government bonds is not available to invest in private sector stocks or bonds. And the competition between private borrowers and the government for the available pool of investment funds often drives up interest rates paid by private bond issuers.

This is where the role of the nation’s central bank, the Federal Reserve, enters the picture. As manager of the nation’s monetary policy, the Fed has its own tools to deal with government deficits. It can buy the various Treasury securities directly and monetize the government’s debt. It does this using its authority to issue currency (more on this in Part II) to pay for these purchases. In the same way, it can enter the open market and purchase the Treasuries from the private buyers who made the initial purchase.

The other power the Fed utilizes is its authority to set various interest rates:

The Fed uses interest rates as a lever to grow the economy or put the brakes on it. If the economy is slowing, the FOMC lowers interest rates to make it cheaper for businesses to borrow money, invest, and create jobs. Lower interest rates also allow consumers to borrow and spend more, which helps spur the economy. 

On the other hand, if the economy is growing too fast and inflation is heating up, the Fed may raise interest rates to curtail spending and borrowing. 

(Source: thebalance.com)

Fact: From 2010 through 2020, the national debt grew from $13.5 trillion to $27 trillion. Inflation averaged 1.7 percent over the same period.

Part II (next Friday)

We will a deeper look at the roles of the government’s fiscal policy and the Fed’s monetary policy and how they interact. We will also consider how Modern Monetary Theory (MMT) may provide a new model for government’s management of the economy. And we’ll take a dive into the motivations of the deficit hawks.

Suggested reading: two books of note, written by economists for non-economists. The Entrepreneurial State by Mariana Mazzucato, explores the role of the public sector in private sector innovation. Stephanie Kelton’s The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy serves as an introduction to MMT as well as presenting policy prescriptions based on this novel theory.

*The Treasury sells three types of tradable securities:

• Treasury bills have maturities of a year or less.

• Treasury notes have maturities from two to ten years.

• Treasury bonds have maturities of 10 to 30 years from their issue date.

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