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Financing Government Deficits with Money

May 10, 2018 6 comments

In an earlier post, I described the budget constraint faced by the federal government. Here I want to point out how a deficit can lead to inflation. I will also indicate how the European Union (EU) and Greece are related to this discussion since there is an interesting difference between the U.S. and Greece regarding deficits and inflation.

Financing Deficits by the Central Bank

Suppose that the government has a deficit meaning that its spending for all purposes exceeds its tax revenue and that the government is unwilling to raise tax rates and/or cut spending. Now imagine that lenders will not lend to the government by buying the bonds that the government has tried to sell. In this situation, one financing option (bond sales to the public) for deficits is unavailable.  If nothing else is done to deal with the deficit, the government simply runs out of money and must shut down its operations until new tax money arises. But there is another option in the U.S. and many other countries; the central bank (the Federal Reserve in the U.S.) can buy the bonds sold by the government.

To see how this works, consider what the Fed can do. The government sells the bonds sold by the government and creates bank reserves as a result. Bank reserves would just be deposits at the Fed owned by banks. Those bank reserves will expand the money stock and so we have the Fed “printing” money to finance the government’s deficit. But to paraphrase the late Milton Friedman, inflation is a monetary phenomenon. Thus the government’s deficit can be accompanied by inflation. This appears to be happening now in the socialist paradise of Venezuela. But for Greece the situation is different because of its membership in the European Union (EU). Read more…

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The Government Budget Constraint

May 3, 2018 1 comment

My last post reported on the latest Congressional Budget Office (CBO) analysis of the federal government budget showing unprecedented increases in the ratio of government debt to GDP. That ratio emerges from the government’s budget constraint which is the topic addressed here.

The Government Budget Constraint

The government’s sources and uses of funds are collected together into one expression, known as the Government Budget Constraint, which states that the sources of funds must equal the uses of funds by the government. The table below lists these items.

Uses of Funds Sources of Funds
Spending on Goods and Services Tax Revenue
Interest Payments Government Bond Issue
Net Transfer Payments

The uses of funds include spending on goods and services, interest payments, and net transfer payments to the public. This latter category includes, among other things, the Social Security and Medicare programs. So Net Transfer Payments rise as the entitlements crisis unfolds. If interest rates on government debt rise, interest payments by the government must rise as well.

On the sources side of the ledger, the government gets tax revenue which it uses to pay for its spending and/or it may issue government bonds to pay for spending if its spending exceeds its tax revenue. So the CBO report said that the government will be running deficits increasing in size into the future and thus will have to issue increasing amounts of government debt to finance its spending.

But this table does not include the role of the Federal Reserve which is included in a related concept which we discuss now. Read more…

The Latest CBO Long-Term Budget Outlook

The Congressional Budget Office (CBO) is the research shop for Congress. It is their job to provide an analysis of many economic issues and one such task is the budget outlook. Their latest report on the budget contains a picture which speaks volumes about the fiscal position of the federal government. That picture is given below.

This picture is the ratio of the stock of government debt to GDP which the CBO expects to arise given their latest projections for the U.S. economy and the laws on the books which dictate government spending by the federal government. Note that the CBO expectation is that the debt/GDP ratio will rise to levels never before seen in the history of the U.S., even during wars. This picture concisely states the nature of the emerging entitlements crisis. Absent any changes in fiscal policy, there will be historically unprecedented levels of government deficits and spending that are implied by current laws.

But there is one hidden aspect of this picture which the CBO is making. The CBO is assuming that it will be possible to finance the deficits implied by this picture but there is no economist that is able to guarantee such a position. The reason is that deficits of the sizes implied here would be well above the trillion dollar range which would be completely outside our history of experience. Thus there is no way to know, since we have never seen these deficits, that a debt crisis would not emerge (the situation with Greece is instructive on this point). Put differently, we cannot guarantee that the federal government would be able to borrow the funds necessary to achieve the debt/GDP ratios in the graph above.

If the government cannot borrow all that is needed, then what? I will write about this in a follow-up post soon.

The Government Deficit and the Fed

April 13, 2017 2 comments

The Federal Reserve recently announced an increase in the interest rate which it sets. This has implications for the government deficit which may not be well understood by the average person so I thought that it might make sense to discuss the connection between the Federal Reserve and the government deficit. What this discussion reveals is that the Fed has been helping to finance the government deficit in the U.S.

The Consolidated Government Budget Constraint

There is a relationship between the government and the Fed known as the Consolidated Government Budget Constraint that is written below.

Spending + Interest Payments + Net Transfer Payments =

Tax Receipts + Change in the Stock of Debt + Change in the Monetary Base

The items on the left side of the equal sign are the uses of the government’s funds. Spending refers to the fact that the government buys goods and services, it makes interest payments to the holders of government debt, and it makes transfer payments to individuals in the economy. The right side of the equation is the list of sources for the government’s spending. It receives tax payments, it issues or retires bonds, and the last item reflects bond purchases or sales by the Federal Reserve. It is these last two items that reflect the connection between the Fed and the government deficit. Read more…

Greece

February 20, 2015 1 comment

Greece has a newly-elected government which campaigned on the promise that, if elected, it would renegotiate the bailout terms that previously were imposed upon the Greek economy by a previous government and its financial bailout partners. The reason for the desire to renegotiate terms is that Greece has been in recession with high unemployment and declining output for some time and the terms of the bailout require higher taxes and reduced spending, among other things, as a requirement for loans to keep the government from defaulting on its debt.  This drama seems to me to offer a number of lessons for the U.S. and other countries running persistent government deficits.

The Fallacy of Composition

Economists know that what is true for an individual in an economy is not necessarily true in the aggregate economy.  This fact is known as the Fallacy of Composition.  So if Greek politicians promise transfer payments to some Greek citizens, this does not imply that those politicians can promise such payments to all citizens.  Once you add up all the promises, one needs to ask how this will be financed and in many countries, such as the U.S., the answer is borrowing to keep these promises. Each individual wants what he or she has been promised but, if a government is unable to borrow, then what is true at the individual level cannot be true in the aggregate. Greece cannot keep all of the promises that it has made because it will not be able to continuously borrow to do so.

Greece and the EU

Greece is a member of the EU and so it cannot print money to cover its deficits if it is unable to borrow.  The reason is that Greece does not control the EU Central Bank.  If it did control its own money stock, it would undoubtedly be in the throes of a hyperinflation because it would be printing money to finance its deficits. Since it cannot print money, it sought loans to keep the party going but reduced spending and higher taxes were the price it paid for its bailout. The recession resulting from these terms are what has prompted the desire to renege on its previous agreement.

Ultimately, structural reforms are needed to promote economic growth, much like those discussed previously in this blog in connection with Italy which has problems similar to Greece (see Why Italy Declines). These reforms are so-called supply-side policies that remove regulatory and other impediments that reduce economic growth. These reforms appear not to be part of the bailout requirements but these reforms are the only way that the Greeks can achieve real economic progress.

Some Modest Good News About the Government’s Deficit

January 14, 2013 Leave a comment

The data is now available measuring the federal government’s deficit for the last calendar year. Here are the numbers for the last two years.

Calendar Year 2011: $1.25 Trillion

Calendar Year 2012: $1.06 Trillion

Source: Financial Management Service (www.fms.treas.gov)

The data actually reveals an approximate 15 percent reduction in the deficit for 2012. Are we now going to hear politicians tell us that the deficit is no longer a problem?

Social Security and the Federal Government Deficit

December 20, 2012 2 comments

Richard Durbin is a senator from Illinois who recently commented on the connection between Social Security and the federal government‘s deficit. Here is a news quote that is easily found: “Social Security does not add one penny to our debt — not a penny.” To say that this is a distortion of the truth is an understatement. For a correct statement about Social Security and the deficit, read this article. The situation can be described as follows.

When the Social Security system was receiving more money than was paid out to Social Security recipients, the excess funds were to be invested into a trust fund consisting of marketable securities. Then, if a time arose where payments to recipients of Social Security exceeded funds received from Social Security taxes, the securities in the trust fund could be sold to generate the payments to Social Security recipients not covered by inflows of tax revenue.

But the government long ago spent the assets in the trust fund, replacing marketable securities in the trust fund with nonmarketable securities. These new securities are really just placeholders for marketable debt that was sold and these new securities cannot be sold to raise the cash needed to pay recipients of Social Security. In the event that Social Security payments are greater than Social Security receipts, the government must sell marketable debt, raising the cash needed to make payments, replacing the nonmarketable debt with the marketable debt newly issued. So when there is a net outflow of funds from the Social Security system, the government must borrow to make the payments that it is legally required to make.

Senator Durbin is superficially correct – there is no net change in the stock of debt since a newly-issued security replaces a nonmarketable older security, leaving the stock of debt unaffected (and, incidentally, this is why Social Security payments have nothing to do with the debt ceiling). But if the government is unable to borrow, say it finds itself in the same position as Greece, then the government will not be able to make all legally-required Social Security payments, unless it prevails upon the Federal Reserve to effectively buy the bonds needed to make the payments. This amounts to using money to finance the government deficit. If there is a debt crisis, defined to be a situation where the government is unable to borrow, then Social Security recipients would not receive their payments absent any action by the Federal Reserve.

To claim that there is no problem with the Social Security system is absurd. As baby boomers retire in greater numbers, the amount of government borrowing will rise correspondingly. Thus there is the risk that, in the future, lenders will be unwilling to lend the increasingly large amounts needed to cover Social Security payments.

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