The right (and wrong) way to buy stocks

July 9, JDN 2457944

Most people don’t buy stocks at all. Stock equity is the quintessential form of financial wealth, and 42% of financial net wealth in the United States is held by the top 1%, while the bottom 80% owns essentially none.

Half of American households do not have any private retirement savings at all, and are depending either on employee pensions or Social Security for their retirement plans.

This is not necessarily irrational. In order to save for retirement, one must first have sufficient income to live on. Indeed, I got very annoyed at a “financial planning seminar” for grad students I attended recently, trying to scare us about the fact that almost none of us had any meaningful retirement savings. No, we shouldn’t have meaningful retirement savings, because our income is currently much lower than what we can expect to get once we graduate and enter our professions. It doesn’t make sense for someone scraping by on a $20,000 per year graduate student stipend to be saving up for retirement, when they can quite reasonably expect to be making $70,000-$100,000 per year once they finally get that PhD and become a professional economist (or sociologist, or psychologist or physicist or statistician or political scientist or material, mechanical, chemical, or aerospace engineer, or college professor in general, etc.). Even social workers, historians, and archaeologists make a lot more money than grad students. If you are already in the workforce and only expect to be getting small raises in the future, maybe you should start saving for retirement in your 20s. If you’re a grad student, don’t bother. It’ll be a lot easier to save once your income triples after graduation. (Personally, I keep about $700 in stocks mostly to get a feel for what it is like owning and trading stocks that I will apply later, not out of any serious expectation to support a retirement fund. Even at Warren Buffet-level returns I wouldn’t make more than $200 a year this way.)

Total US retirement savings are over $25 trillion, which… does actually sound low to me. In a country with a GDP now over $19 trillion, that means we’ve only saved a year and change of total income. If we had a rapidly growing population this might be fine, but we don’t; our population is fairly stable. People seem to be relying on economic growth to provide for their retirement, and since we are almost certainly at steady-state capital stock and fairly near full employment, that means waiting for technological advancement.

So basically people are hoping that we get to the Wall-E future where the robots will provide for us. And hey, maybe we will; but assuming that we haven’t abandoned capitalism by then (as they certainly haven’t in Wall-E), maybe you should try to make sure you own some assets to pay for robots with?

But okay, let’s set all that aside, and say you do actually want to save for retirement. How should you go about doing it?

Stocks are clearly the way to go. A certain proportion of government bonds also makes sense as a hedge against risk, and maybe you should even throw in the occasional commodity future. I wouldn’t recommend oil or coal at this point—either we do something about climate change and those prices plummet, or we don’t and we’ve got bigger problems—but it’s hard to go wrong with corn or steel, and for this one purpose it also can make sense to buy gold as well. Gold is not a magical panacea or the foundation of all wealth, but its price does tend to correlate negatively with stock returns, so it’s not a bad risk hedge.

Don’t buy exotic derivatives unless you really know what you’re doing—they can make a lot of money, but they can lose it just as fast—and never buy non-portfolio assets as a financial investment. If your goal is to buy something to make money, make it something you can trade at the click of a button. Buy a house because you want to live in that house. Buy wine because you like drinking wine. Don’t buy a house in the hopes of making a financial return—you’ll have leveraged your entire portfolio 10 to 1 while leaving it completely undiversified. And the problem with investing in wine, ironically, is its lack of liquidity.

The core of your investment portfolio should definitely be stocks. The biggest reason for this is the equity premium; equities—that is, stocks—get returns so much higher than other assets that it’s actually baffling to most economists. Bond returns are currently terrible, while stock returns are currently fantastic. The former is currently near 0% in inflation-adjusted terms, while the latter is closer to 16%. If this continues for the next 10 years, that means that $1000 put in bonds would be worth… $1000, while $1000 put in stocks would be worth $4400. So, do you want to keep the same amount of money, or quadruple your money? It’s up to you.

Higher risk is generally associated with higher return, because rational investors will only accept additional risk when they get some additional benefit from it; and stocks are indeed riskier than most other assets, but not that much riskier. For this to be rational, people would need to be extremely risk-averse, to the point where they should never drive a car or eat a cheeseburger. (Of course, human beings are terrible at assessing risk, so what I really think is going on is that people wildly underestimate the risk of driving a car and wildly overestimate the risk of buying stocks.)

Next, you may be asking: How does one buy stocks? This doesn’t seem to be something people teach in school.

You will need a brokerage of some sort. There are many such brokerages, but they are basically all equivalent except for the fees they charge. Some of them will try to offer you various bells and whistles to justify whatever additional cut they get of your trades, but they are almost never worth it. You should choose one that has a low a trade fee as possible, because even a few dollars here and there can add up surprisingly quickly.

Fortunately, there is now at least one well-established reliable stock brokerage available to almost anyone that has a standard trade fee of zero. They are called Robinhood, and I highly recommend them. If they have any downside, it is ironically that they make trading too easy, so you can be tempted to do it too often. Learn to resist that urge, and they will serve you well and cost you nothing.

Now, which stocks should you buy? There are a lot of them out there. The answer I’m going to give may sound strange: All of them. You should buy all the stocks.

All of them? How can you buy all of them? Wouldn’t that be ludicrously expensive?

No, it’s quite affordable in fact. In my little $700 portfolio, I own every single stock in the S&P 500 and the NASDAQ. If I get a little extra money to save, I may expand to own every stock in Europe and China as well.

How? A clever little arrangement called an exchange-traded fund, or ETF for short. An ETF is actually a form of mutual fund, where the fund purchases shares in a huge array of stocks, and adjusts what they own to precisely track the behavior of an entire stock market (such as the S&P 500). Then what you can buy is shares in that mutual fund, which are usually priced somewhere between $100 and $300 each. As the price of stocks in the market rises, the price of shares in the mutual fund rises to match, and you can reap the same capital gains they do.

A major advantage of this arrangement, especially for a typical person who isn’t well-versed in stock markets, is that it requires almost no attention at your end. You can buy into a few ETFs and then leave your money to sit there, knowing that it will grow as long as the overall stock market grows.

But there is an even more important advantage, which is that it maximizes your diversification. I said earlier that you shouldn’t buy a house as an investment, because it’s not at all diversified. What I mean by this is that the price of that house depends only on one thing—that house itself. If the price of that house changes, the full change is reflected immediately in the value of your asset. In fact, if you have 10% down on a mortgage, the full change is reflected ten times over in your net wealth, because you are leveraged 10 to 1.

An ETF is basically the opposite of that. Instead of its price depending on only one thing, it depends on a vast array of things, averaging over the prices of literally hundreds or thousands of different corporations. When some fall, others will rise. On average, as long as the economy continues to grow, they will rise.

The result is that you can get the same average return you would from owning stocks, while dramatically reducing the risk you bear.

To see how this works, consider the past year’s performance of Apple (AAPL), which has done very well, versus Fitbit (FIT), which has done very poorly, compared with the NASDAQ as a whole, of which they are both part.

AAPL has grown over 50% (40 log points) in the last year; so if you’d bought $1000 of their stock a year ago it would be worth $1500. FIT has fallen over 60% (84 log points) in the same time, so if you’d bought $1000 of their stock instead, it would be worth only $400. That’s the risk you’re taking by buying individual stocks.

Whereas, if you had simply bought a NASDAQ ETF a year ago, your return would be 35%, so that $1000 would be worth $1350.

Of course, that does mean you don’t get as high a return as you would if you had managed to choose the highest-performing stock on that index. But you’re unlikely to be able to do that, as even professional financial forecasters are worse than random chance. So, would you rather take a 50-50 shot between gaining $500 and losing $600, or would you prefer a guaranteed $350?

If higher return is not your only goal, and you want to be socially responsible in your investments, there are ETFs for that too. Instead of buying the whole stock market, these funds buy only a section of the market that is associated with some social benefit, such as lower carbon emissions or better representation of women in management. On average, you can expect a slightly lower return this way; but you are also helping to make a better world. And still your average return is generally going to be better than it would be if you tried to pick individual stocks yourself. In fact, certain classes of socially-responsible funds—particularly green tech and women’s representation—actually perform better than conventional ETFs, probably because most investors undervalue renewable energy and, well, also undervalue women. Women CEOs perform better at lower prices; why would you not want to buy their companies?

In fact ETFs are not literally guaranteed—the market as a whole does move up and down, so it is possible to lose money even by buying ETFs. But because the risk is so much lower, your odds of losing money are considerably reduced. And on average, an ETF will, by construction, perform exactly as well as the average performance of a randomly-chosen stock from that market.

Indeed, I am quite convinced that most people don’t take enough risk on their investment portfolios, because they confuse two very different types of risk.

The kind you should be worried about is idiosyncratic risk, which is risk tied to a particular investment—the risk of having chosen the Fitbit instead of Apple. But a lot of the time people seem to be avoiding market risk, which is the risk tied to changes in the market as a whole. Avoiding market risk does reduce your chances of losing money, but it does so at the cost of reducing your chances of making money even more.

Idiosyncratic risk is basically all downside. Yeah, you could get lucky; but you could just as well get unlucky. Far better if you could somehow average over that risk and get the average return. But with diversification, that is exactly what you can do. Then you are left only with market risk, which is the kind of risk that is directly tied to higher average returns.

Young people should especially be willing to take more risk in their portfolios. As you get closer to retirement, it becomes important to have more certainty about how much money will really be available to you once you retire. But if retirement is still 30 years away, the thing you should care most about is maximizing your average return. That means taking on a lot of market risk, which is then less risky overall if you diversify away the idiosyncratic risk.

I hope now that I have convinced you to avoid buying individual stocks. For most people most of the time, this is the advice you need to hear. Don’t try to forecast the market, don’t try to outperform the indexes; just buy and hold some ETFs and leave your money alone to grow.

But if you really must buy individual stocks, either because you think you are savvy enough to beat the forecasters or because you enjoy the gamble, here’s some additional advice I have for you.

My first piece of advice is that you should still buy ETFs. Even if you’re willing to risk some of your wealth on greater gambles, don’t risk all of it that way.

My second piece of advice is to buy primarily large, well-established companies (like Apple or Microsoft or Ford or General Electric). Their stocks certainly do rise and fall, but they are unlikely to completely crash and burn the way that young companies like Fitbit can.

My third piece of advice is to watch the price-earnings ratio (P/E for short). Roughly speaking, this is the number of years it would take for the profits of this corporation to pay off the value of its stock. If they pay most of their profits in dividends, it is approximately how many years you’d need to hold the stock in order to get as much in dividends as you paid for the shares.

Do you want P/E to be large or small? You want it to be small. This is called value investing, but it really should just be called “investing”. The alternatives to value investing are actually not investment but speculation and arbitrage. If you are actually investing, you are buying into companies that are currently undervalued; you want them to be cheap.

Of course, it is not always easy to tell whether a company is undervalued. A common rule-of-thumb is that you should aim for a P/E around 20 (20 years to pay off means about 5% return in dividends); if the P/E is below 10, it’s a fantastic deal, and if it is above 30, it might not be worth the price. But reality is of course more complicated than this. You don’t actually care about current earnings, you care about future earnings, and it could be that a company which is earning very little now will earn more later, or vice-versa. The more you can learn about a company, the better judgment you can make about their future profitability; this is another reason why it makes sense to buy large, well-known companies rather than tiny startups.

My final piece of advice is not to trade too frequently. Especially with something like Robinhood where trades are instant and free, it can be tempting to try to ride every little ripple in the market. Up 0.5%? Sell! Down 0.3%? Buy! And yes, in principle, if you could perfectly forecast every such fluctuation, this would be optimal—and make you an almost obscene amount of money. But you can’t. We know you can’t. You need to remember that you can’t. You should only trade if one of two things happens: Either your situation changes, or the company’s situation changes. If you need the money, sell, to get the money. If you have extra savings, buy, to give those savings a good return. If something bad happened to the company and their profits are going to fall, sell. If something good happened to the company and their profits are going to rise, buy. Otherwise, hold. In the long run, those who hold stocks longer are better off.

Fear not the deficit

JDN 2456984 PST 12:20.

The deficit! It’s big and scary! And our national debt is rising by the second, says a “debt clock” that is literally just linearly extrapolating the trend. You don’t actually think that there are economists marking down every single dollar the government spends and uploading it immediately, do you? We’ve got better things to do. Conservatives will froth at the mouth over how Obama is the “biggest government spender in world history“, which is true if you just look at the dollar amounts, but of course it is; Obama is the president of the richest country in world history. If the government continues to tax at the same rate and spend what it taxes, government spending will be a constant proportion of GDP (which isn’t quite true, but it’s pretty close; there are ups and downs but for the last 40 years or so federal spending is generally in the range 30% to 35% of GDP), and the GDP of the United States is huge, and far beyond that of any other nation not only today, but ever. This is particularly true if you use nominal dollars, but it’s even true if you use inflation-adjusted real GDP. No other nation even gets close to US GDP, which is about to reach $17 trillion a year (unless you count the whole European Union as a nation, in which case it’s a dead heat).

China recently passed us if you use purchasing-power-parity, but that really doesn’t mean much, because purchasing-power-parity, or PPP, is a measure of standard of living, not a measure of a nation’s total economic power. If you want to know how well people in a country live, you use GDP per capita (that is, per person) PPP. But if you want to know a country’s capacity to influence the world economy, what matters is so-called real GDP, which is adjusted for inflation and international exchange rates. The difference is that PPP will tell you how many apples a person can buy, but real GDP will tell you how many aircraft carriers a government can build. The US is still doing quite well in that department, thank you; we have 10 of the world’s 20 active aircraft carriers, which is to say as many as everyone else combined. The US has 4% of the world’s population and 24% of the world’s economic output.

In particular, GDP in the US has been growing rather steadily since the Great Recession, and we are now almost recovered from the Second Depression and back to our equilibrium level of unemployment and economic growth. As the economy grows, government spending grows alongside it. Obama has actually presided over a decrease in the proportion of government spending relative to GDP, largely because of all this political pressure to reduce the deficit and stop the growth of the national debt. Under Obama the deficit has dropped dramatically.

But what is the deficit, anyway? And how can the deficit be decreasing if the debt clock keeps ticking up?

The government deficit is simply the difference between total government spending and total government revenue. If the government spends $3.90 trillion and takes in $3.30 trillion, the deficit is going to be $0.60 trillion, or $600 billion. In the rare case that you take in more than you spend, the deficit would be negative; we call that a surplus instead. (This almost never happens.)

Because of the way the US government is financed, the deficit corresponds directly to the national debt, which is the sum of all outstanding loans to the government. Every time the government spends more than it takes in, it makes up the difference by taking out a loan, in the form of a Treasury bond. As long as the deficit is larger than zero, the debt will increase. Think of the debt as where you are, and the deficit as how fast you’re going; you can be slowing down, but you’ll continue to move forward as long as you have some forward momentum.

Who is giving us these loans? You can look at the distribution of bondholders here. About a third of the debt is owned by the federal government itself, which makes it a very bizarre notion of “debt” indeed. Of the rest, 21% is owned by states or the Federal Reserve, so that’s also a pretty weird kind of debt. Only 55% of the total debt is owned by the public, and of those 39% are people and corporations within the United States. That means that only 33% of the national debt is actually owned by foreign people, corporations, or governments. What we actually owe to China is about $1.4 trillion. That’s a lot of money (it’s literally enough to make an endowment that would end world hunger forever), but our total debt is almost $18 trillion, so that’s only 8%.

When most people see these huge figures they panic: “Oh my god, we owe $18 trillion! How will we ever repay that!” Well, first of all, our GDP is $17 trillion, so we only owe a little over one year of income. (I wish I only owed one year of income in student loans….)

But in fact we don’t really owe it at all, and we don’t need to ever repay it. Chop off everything that’s owned by US government institutions (including the Federal Reserve, which is only “quasi-governmental”), and the figure drops down to $9.9 trillion. If by we you mean American individuals and corporations, then obviously we don’t owe back the debt that’s owned by ourselves, so take that off; now you’re looking at $6 trillion. That’s only about 4 months of total US economic output, or less than two years of government revenue.

And it gets better! The government doesn’t need to somehow come up with that money; they don’t even have to raise it in taxes. They can print that money, because the US government has a sovereign currency and the authority to print as much as we want. Really, we have the sovereign currency, because the US dollar is the international reserve currency, the currency that other nations hold in order to make exchanges in foreign markets. Other countries buy our money because it’s a better store of value than their own. Much better, in fact; the US has the most stable inflation rate in the world, and has literally never undergone hyperinflation. Better yet, the last time we had prolonged deflation was the Great Depression. This system is self-perpetuating, because being the international reserve currency also stabilizes the value of your money.

This is why it’s so aggravating to me when people say things like “the government can’t afford that” or “the government is broke” or “that money needs to come from somewhere”. No, the government can’t be broke! No, the money doesn’t have to come from somewhere! The US government is the somewhere from which the world’s money comes. If there is one institution in the world that can never, ever be broke, it is the US government. This gives our government an incredible amount of power—combine that with our aforementioned enormous GDP and fleet of aircraft carriers, and you begin to see why the US is considered a global hegemon.

To be clear: I’m not suggesting we eliminate all taxes and just start printing money to pay for everything. Taxes are useful, and we should continue to have them—ideally we would make them more progressive than they presently are. But it’s important to understand why taxes are useful; it’s really not that they are “paying for” government services. It’s actually more that they are controlling the money supply. The government creates money by spending, then removes money by taxing; in this way we maintain a stable growth of the money supply that allows us to keep the economy running smoothly and maintain inflation at a comfortable level. Taxes also allow the government to redistribute income from those who have it and save it to those who need it and will spend it—which is all the more reason for them to be progressive. But in theory we could eliminate all taxes without eliminating government services; it’s just that this would cause a surge in inflation. It’s a bad idea, but by no means impossible.

When we have a deficit, the national debt increases. This is not a bad thing. This is a fundamental misconception that I hope to disabuse you of: Government debt is not like household debt or corporate debt. When people say things like “we need to stop spending outside our means” or “we shouldn’t put wars on the credit card”, they are displaying a fundamental misunderstanding of what government debt is. The government simply does not operate under the same kind of credit constraints as you and I.

First, the government controls its own interest rates, and they are always very low—typically the lowest in the entire economy. That already gives it a lot more power over its debt than you or I have over our own.

Second, the government has no reason to default, because they can always print more money. That’s probably why bondholders tolerate the fact that the government sets its own interest rates; sure, it only pays 0.5%, but it definitely pays that 0.5%.

Third, government debt plays a role in the functioning of global markets; one of the reasons why China is buying up so much of our debt is so that they can keep the dollar high in value and thus maintain their trade surplus. (This is why whenever someone says something like, “The government needs to stop going further into debt, just like how I tightened my belt and paid off my mortgage!” I generally reply, “So when was the last time someone bought your debt in order to prop up your currency?”) This is also why we can’t get rid of our trade deficit and maintain a “strong dollar” at the same time; anyone who wants to do that may feel patriotic, but they are literally talking nonsense. The stronger the dollar, the higher the trade deficit.

Fourth, as I already hinted at above, the government doesn’t actually need debt at all. Government debt, like taxation, is not actually a source of funding; it is a tool of monetary policy. (If you’re going to quote one sentence from this post, it should be the previous; that basically sums up what I’m saying.) Even without raising taxes or cutting spending, the government could choose not to issue bonds, and instead print cash. You could make a sophisticated economic argument for how this is really somehow “issuing debt with indefinite maturity at 0% interest”; okay, fine. But it’s not what most people think of when they think of debt. (In fact, sophisticated economic arguments can go quite the opposite way: there’s a professor at Harvard I may end up working with—if I get into Harvard for my PhD of course—who argues that the federal debt and deficit are literally meaningless because they can be set arbitrarily by policy. I think he goes too far, but I see his point.) This is why many economists were suggesting that in order to get around ridiculous debt-ceiling intransigence Obama could simply Mint the Coin.

Government bonds aren’t really for the benefit of the government, they’re for the benefit of society. They allow the government to ensure that there is always a perfectly safe investment that people can buy into which will anchor interest rates for the rest of the economy. If we ever did actually pay off all the Treasury bonds, the consequences could be disastrous.

Fifth, the government does not have a credit limit; they can always issue more debt (unless Congress is filled with idiots who won’t raise the debt ceiling!). The US government is the closest example in the world to what neoclassical economists call a perfect credit market. A perfect credit market is like an ideal rational agent; these sort of things only exist in an imaginary world of infinite identical psychopaths. A perfect credit market would have perfect information, zero transaction cost, zero default risk, and an unlimited quantity of debt; with no effort at all you could take out as much debt as you want and everyone would know that you are always guaranteed to pay it back. This is in most cases an utterly absurd notion—but in the case of the US government it’s actually pretty close.

Okay, now that I’ve deluged you with reasons why the national debt is fundamentally different from a household mortgage or corporate bond, let’s get back to talking about the deficit. As I mentioned earlier, the deficit is almost always positive; the government is almost always spending more money than it takes in. Most people think that is a bad thing; it is not.

It would be bad for a corporation to always run a deficit, because then it would never make a profit. But the government is not a for-profit corporation. It would be bad for an individual to always run a deficit, because eventually they would go bankrupt. But the government is not an individual.

In fact, the government running a deficit is necessary for both corporations to make profits and individuals to gain net wealth! The government is the reason why our monetary system is nonzero-sum.

This is actually so easy to see that most people who learn about it react with shock, assuming that it can’t be right. There can’t be some simple and uncontroversial equation that shows that government deficits are necessary for profits and savings. Actually, there is; and the fact that we don’t talk about this more should tell you something about the level of sophistication in our economic discourse.

Individuals do work, get paid wages W. (This also includes salaries and bonuses; it’s all forms of labor income.) They also get paid by government spending, G, and pay taxes, T. Let’s pretend that all taxing and spending goes to people and not corporations. This is pretty close to true, especially since corporations as big as Boeing frequently pay nothing in taxes. Corporate subsidies, while ridiculous, are also a small portion of spending—no credible estimate is above $300 billion a year, or less than 10% of the budget. (Without that assumption the equation has a couple more terms, but the basic argument doesn’t change.) People use their money to buy consumption goods, C. What they don’t spend they save, S.

S = (W + G – T) – C

I’m going to rearrange this for reasons that will soon become clear:

S = (W – C) + (G – T)

I’ll also subtract investment I from both sides, again for reasons that will become clear:

S – I = (W – C – I) + (G – T)

Corporations hire workers and pay them W. They make consumption goods which are then sold for C. They also sell to foreign companies and buy from foreign companies, exporting X and importing M. Since we have a trade deficit, this means that X < M. Finally, they receive investment I that comes in the form of banks creating money through loans (yes, banks can create money). Most of our monetary policy is in the form of trying to get banks to create more money by changing interest rates. Only when desperate do we actually create the money directly (I’m not sure why we do it this way). In any case, this yields a total net profit P.

P = C + I – W + (X – M)

Now, if the economy is functioning well, we want profits and savings to both be positive—both people and corporations will have more money on average next year then they had this year. This means that S > 0 and P > 0. We also don’t want the banks loaning out more money than people save—otherwise people go ever further into debt—so we actually want S > I, or S – I > 0. If S – I > 0, people are paying down their debts and gaining net wealth. If S – I < 0, people are going further into debt and losing net wealth. In a well-functioning economy we want people to be gaining net wealth.

In order to have P > 0, because X – M < 0 we need to have C + I > W. People have to spend more on consumption and investment than they are paid in wages—have to, absolutely have to, as a mathematical law—in order for corporations to make a profit.

But then if C + I > W, W – C – I < 0, which means that the first term of the savings equation is negative. In order for savings to be positive, it must be—again as a mathematical law—that G – T > 0, which means that government spending exceeds taxes. In order for both corporations to profit and individuals to save at the same time, the government must run a deficit.

There is one other way, actually, and that’s for X – M to be positive, meaning you run a trade surplus. But right now we don’t, and moreover, the world as a whole necessarily cannot. For the world as a whole, X = M. This will remain true at least until we colonize other planets. This means that in order for both corporate profits and individual savings to be positive worldwide, overall governments worldwide must spend more than they take in. It has to be that way, otherwise the equations simply don’t balance.

You can also look at it another way by adding the equations for S – I and P:

S – I + P = (G – T) + (X – M)

Finally, you can also derive this a third way. This is your total GDP which we usually call Y (“yield”, I think?); it’s equal to consumption plus investment plus government spending, plus net exports:

Y = C + I + G + (X – M)

It’s also equal to consumption plus profit plus saving plus taxes:

Y = C + P + S + T

So those two things must be the same:

C + S + T + P = C + I + G + (X – M)

Canceling and rearranging we get:

(S – I) + P = (G – T) + (X – M)

The sum of saving minus investment (which we can sort of think of as “net saving”) plus profit is equal to the sum of the government deficit and the trade surplus. (Usually you don’t see P in this sectoral balances equation because no distinction is made between consumers and corporations and P is absorbed into S.)

From the profit equation:

W = C + I + (X – M) – P

Put that back into our GDP equation:

Y = W + P + G

GDP is wages plus profits plus government spending.

That’s a lot of equations; simple equations, but yes, equations. Lots of people are scared by equations. So here, let me try to boil it down to a verbal argument. When people save and corporations make profits, money gets taken out of circulation. If no new money is added, the money supply will decrease as a result; this shrinks the economy (mathematically it must absolutely shrink it in nominal terms; theoretically it could cause deflation and not reduce real output, but in practice real output always goes down because deflation causes its own set of problems). New money can be created by banks, but the mechanism of creation requires that people go further into debt. This is unstable, and eventually people can’t borrow anymore and the whole financial system comes crashing down. The better way, then, is for the government to create new money. Yes, as we currently do things, this means the government will go further into debt; but that’s all right, because the government can continue to increase its debt indefinitely without having to worry about hitting a ceiling and making everything fall apart. We could also just print money instead, and in fact I think in many cases this is what we should do—but for whatever reason people always freak out when you suggest such a thing, invariably mentioning Zimbabwe. (And yes, Zimbabwe is in awful shape; but they didn’t just print money to cover a reasonable amount of deficit spending. They printed money to line their own pockets, and it was thousands of times more than what I’m suggesting. Also Zimbabwe has a much smaller economy; $1 trillion is 5% of US GDP, but it’s 8,000% of Zimbabwe’s. I’m suggesting we print maybe 4% of GDP; at the peak of the hyperinflation they printed something more like 100,000%.)

One last thing before I go. If investment suddenly drops, net saving will go up. If the government deficit and trade deficit remain constant, profits must go down. This drives firms into bankruptcy, driving wages down as well. This makes GDP fall—and you get a recession. A similar effect would occur if consumption suddenly drops. In both cases people will be trying to increase their net wealth, but in fact they won’t be able to—this is what’s called the paradox of thrift. You actually want to increase the government deficit under these circumstances, because then you will both add to GDP directly and allow profits and wages to go back up and raise GDP even further. Because GDP has gone down, tax income will go down, so if you insist on balancing the budget, you’ll cut spending and only make things worse.

Raising the government deficit generally increases economic growth. From these simple equations it looks like you could raise GDP indefinitely, but these are nominal figures—actual dollar amounts—so after a certain point all you’d be doing is creating inflation. Where exactly that point is depends on how your economy is performing relative to its potential capacity. In a recession you are far below capacity, so that’s just the time to spend. You’d only want a budget surplus if you actually thought you were above long-run capacity, because you’re depleting natural resources or causing too much inflation or something like that. And indeed, we hardly ever see budget surpluses.

So that, my dear reader, is why we don’t need to fear the deficit. Government debt is nothing like other forms of debt; profits and savings depend upon the government spending more than it takes in; deficits are highly beneficial during recessions; and the US government is actually in a unique position to never worry about defaulting on its debt.