How about we listen to the Nobel Laureate when we set our taxes?

JDN 2457321 EDT 11:20

I know I’m going out on a limb here, but I think it would generally be a good thing if we based our tax system on the advice of Nobel Laureate economists. Joseph Stiglitz wrote a tax policy paper for the Roosevelt Institution last year that describes in detail how our tax system could be reformed to simultaneously restore economic growth, reduce income inequality, promote environmental sustainability, and in the long run even balance the budget. What’s more, he did the math (I suppose Nobel Laureate economists are known for that), and it looks like his plan would actually work.

The plan is good enough that I think it’s worth going through in some detail.

He opens by reminding us that our “debt crisis” is of our own making, the result of politicians (and voters) who don’t understand economics:

“But we should be clear that these crises – which have resulted in a government shutdown and a near default on the national debt – are not economic but political. The U.S. is not like Greece, unable to borrow to fund its debt and deficit. Indeed, the U.S. has been borrowing at negative real interest rates.”

Stiglitz pulls no punches against bad policies, and isn’t afraid to single out conservatives:

“We also show that some of the so-called reforms that conservatives propose would be counterproductive – they could simultaneously reduce growth and economic welfare and increase unemployment and inequality. It would be better to have no reform than these reforms.”

A lot of the news media keep trying to paint Bernie Sanders as a far-left radical candidate (like this article in Politico calling his hometown the “People’s Republic of Burlington”), because he says things like this: “in recent years, over 99 percent of all new income generated in the economy has gone to the top 1 percent.”

But the following statement was not said by Bernie Sanders, it was said by Joseph Stiglitz, who I will remind you one last time is a world-renowned Nobel Laureate economist:

“The weaknesses in the labor market are reflected in low wages and stagnating incomes. That helps explain why 95 percent of the increase in incomes in the three years after the recovery officially began went to the upper 1 percent. For most Americans, there has been no recovery.”

It was also Stiglitz who said this:

“The American Dream is, in reality, a myth. The U.S. has some of the worst inequality across generations (social mobility) among wealthy nations. The life prospects of a young American are more dependent on the income and education of his parents than in other advanced countries.”

In this country, we have reached the point where policies supported by the analysis of world-renowned economists is considered far-left radicalism, while the “mainstream conservative” view is a system of tax policy that is based on pure fantasy, which has been called “puppies and rainbows” by serious policy analysts and “voodoo economics” by yet another Nobel Laureate economist. A lot of very smart people don’t understand what’s happening in our political system, and want “both sides” to be “equally wrong”, but that is simply not the case: Basic facts of not just social science (e.g. Keynesian monetary policy), but indeed natural science (evolutionary biology, anthropogenic climate change) are now considered “political controversies” because the right wing doesn’t want to believe them.

But let’s get back to the actual tax plan Stiglitz is proposing. He is in favor of raising some taxes and lowering others, spending more on some things and less on other things. His basic strategy is actually quite simple: Raise taxes with low multipliers and cut taxes with high multipliers. Raise spending with high multipliers and cut spending with low multipliers.

“While in general taxes take money out of the system, and therefore have a deflationary bias, some taxes have a larger multiplier than others, i.e. lead to a greater reduction in aggregate demand per dollar of revenue raised. Taxes on the rich and superrich, who save a large fraction of their income, have the least adverse effect on aggregate demand. Taxes on lower income individuals have the most adverse effect on aggregate demand.”

In other words, by making the tax system more progressive, we can directly stimulate economic growth while still increasing the amount of tax revenue we raise. And of course we have plenty of other moral and economic reasons to prefer progressive taxation.

Stiglitz tears apart the “job creator” myth:

“It is important to dispel a misunderstanding that one often hears from advocates of lower taxes for the rich and corporations, which contends that the rich are the job producers, and anything that reduces their income will reduce their ability and incentive to create jobs. First, at the current time, it is not lack of funds that is holding back investment. It is not even a weak and dysfunctional financial sector. America’s large corporations are sitting on more than $2 trillion in cash. What is holding back investment, especially by large corporations, is the lack of demand for their products.”

Stiglitz talks about two principles of taxation to follow:

First is the Generalized Henry George Principle, that we should focus taxes on things that are inelastic, meaning their supply isn’t likely to change much with the introduction of a tax. Henry George favored taxing land, which is quite inelastic indeed. The reason we do this is to reduce the economic distortions created by a tax; the goal is to collect revenue without changing the number of real products that are bought and sold. We need to raise revenue and we want to redistribute income, but we want to do it without creating unnecessary inefficiencies in the rest of the economy.

Second is the Generalized Polluter Pays Principle, that we should tax things that have negative externalities—effects on other people that are harmful. When a transaction causes harm to others who were not party to the transaction, we should tax that transaction in an amount equal to the harm that it would cause, and then use that revenue to offset the damage. In effect, if you hurt someone else, you should have to pay to clean up your own mess. This makes obvious moral sense, but it also makes good economic sense; taxing externalities can improve economic efficiency and actually make everyone better off. The obvious example is again pollution (the original Polluter Pays Principle), but there are plenty of other examples as well.

Stiglitz of course supports taxes on pollution and carbon emissions, which really should be a no-brainer. They aren’t just good for the environment, they would directly increase economic efficiency. The only reason we don’t have comprehensive pollution taxes (or something similar like cap-and-trade) is again the political pressure of right-wing interests.

Stiglitz focuses in particular on the externalities of the financial system, the boom-and-bust cycle of bubble, crisis, crash that has characterized so much of our banking system for generations. With a few exceptions, almost every major economic crisis has been preceded by some sort of breakdown of the financial system (and typically widespread fraud by the way). It is not much exaggeration to say that without Wall Street there would be no depressions. Externalities don’t get a whole lot bigger than that.

Stiglitz proposes a system of financial transaction taxes that are designed to create incentives against the most predatory practices in finance, especially the high-frequency trading in which computer algorithms steal money from the rest of the economy thousands of times per second. Even a 0.01% tax on each financial transaction would probably be enough to eliminate this particular activity.

He also suggests the implementation of “bonus taxes” which disincentivize paying bonuses, which could basically be as simple as removing the deductions placed during the Clinton administration (in a few years are we going to have to say “the first Clinton administration”?) that exempt “performance-based pay” from most forms of income tax. All pay is performance-based, or supposed to be. There should be no special exemption for bonuses and stock options.

Stiglitz also proposes a “bank rescue fund” which would be something like an expansion of the FDIC insurance that banks are already required to have, but designed as catastrophe insurance for the whole macroeconomy. Instead of needing bailed out from general government funds, banks would only be bailed out from a pool of insurance funds they paid in themselves. This could work, but honestly I think I’d rather reduce the moral hazard even more by saying that we will never again bail out banks directly, but instead bail out consumers and real businesses. This would probably save banks anyway (most people don’t default on debts if they can afford to pay them), and if it doesn’t, I don’t see why we should care. The only reason banks exist is to support the real economy; if we can support the real economy without them, they deserve to die. That basic fact seems to have been lost somewhere along the way, and we keep talking about how to save or stabilize the financial system as if it were valuable unto itself.

Stiglitz also proposes much stricter regulations on credit cards, which would require them to charge much lower transaction fees and also pay a portion of their transaction revenue in taxes. I think it’s fair to ask whether we need credit cards at all, or if there’s some alternative banking system that would allow people to make consumer purchases without paying 20% annual interest. (It seems like there ought to be, doesn’t it?)

Next Stiglitz gets to his proposal to reform the corporate income tax. Like many of us, he is sick of corporations like Apple and GE with ten and eleven-figure profits paying little or no taxes by exploiting a variety of loopholes. He points out some of the more egregious ones, like the “step up of basis at death” which allows inherited capital to avoid taxation (personally, I think both morally and economically the optimal inheritance tax rate is 100%!), as well as the various loopholes on offshore accounting which allow corporations to design and sell their products in the US, even manufacture them here, and pay taxes as if all their work were done in the Cayman Islands. He also points out that the argument that corporate taxes disincentivize investment is ridiculous, because most investment is financed by corporate bonds which are tax-deductible.

Stiglitz departs from most other economists in that he actually proposes raising the corporate tax rate itself. Most economists favor cutting the rate on paper, then closing the loopholes to ensure that the new rate is actually paid. Stiglitz says this is not enough, and we must both close the loopholes and increase the rate.

I’m actually not sure I agree with him on this; the incidence of corporate taxes is not very well-understood, and I think there’s a legitimate worry that taxing Apple will make iPhones more expensive without actually taking any money from Tim Cook. I think it would be better to get rid of the corporate tax entirely and then dramatically raise the marginal rates on personal income, including not only labor income but also all forms of capital income. Instead of taxing Apple hoping it will pass through to Tim Cook, I say we just tax Tim Cook. Directly tax his $4 million salary and $70 million in stock options.

Stiglitz does have an interesting proposal to introduce “rent-seeking” taxes that specifically apply to corporations which exercise monopoly or oligopoly power. If you can actually get this to work, it’s very clever; you could actually create a market incentive for corporations to support their own competition—and not in the sense of collusion but in the sense of actually trying to seek out more competitive markets in order to avoid the monopoly tax. Unfortunately, Stiglitz is a little vague on how we’d actually pull that off.

One thing I do agree with Stiglitz on is the use of refundable tax credits to support real investment. Instead of this weird business about not taxing dividends and capital gains in the hope that maybe somehow this will support real investment, we actually give tax credits specifically to companies that build factories or hire more workers.

Stiglitz also does a good job of elucidating the concept of “corporate welfare”, officially called “tax expenditures”, in which subsidies for corporations are basically hidden in the tax code as rebates or deductions. This is actually what Obama was talking about when he said “spending in the tax code”, (he did not invent the concept of tax expenditures), but since he didn’t explain himself well even Jon Stewart accused him of Orwellian Newspeak. Economically a refundable tax rebate of $10,000 is exactly the same thing as a subsidy of $10,000. There are some practical and psychological differences, but there are no real economic differences. If you’re still confused about tax expenditures, the Center for American Progress has a good policy memo on the subject.

Stiglitz also has some changes to make to the personal income tax, all of which I think are spot-on. First we increase the marginal rates, particularly at the very top. Next we equalize rates on all forms of income, including capital income. Next, we remove most, if not all, of the deductions that allow people to avoid paying the rate it says on paper. Finally, we dramatically simplify the tax code so that the majority of people can file a simplified return which basically just says, “This is my income. This is the tax rate for that income. This is what I owe.” You wouldn’t have to worry about itemizing your student loans or mortgage payments or whatever else; just tally up your income and look up your rate. As he points out, this would save a lot of people a lot of stress and also remove a lot of economic distortions.

He talks about how we can phase out the mortgage-interest deduction in particular, because it’s clearly inefficient and regressive but it’s politically popular and dropping it suddenly could lead to another crisis in housing prices.

Stiglitz has a deorbit for anyone who thinks capital income should not be taxed:

“There is, moreover, no justification for taxing those who work hard to earn a living at a higher rate than those who derive their income from speculation.”

By equalizing rates on labor and capital income, he estimates we could raise an additional $130 billion per year—just shy of what it would take to end world hunger. (Actually some estimates say it would be more than enough, others that it would be about half what we need. It’s definitely in the ballpark, however.)

Stiglitz actually proposes making a full deduction of gross household income at $100,000, meaning that the vast majority of Americans would pay no income tax at all. This is where he begins to lose me, because it necessarily means we aren’t going to raise enough revenue by income taxes alone.

He proposes to make up the shortfall by introducing a value-added tax, a VAT. I have to admit a lot of countries have these (including most of Europe) and seem to do all right with them; but I never understood why they are so popular among economists. They are basically sales taxes, and it’s very hard to make any kind of sales tax meaningfully progressive. In fact, they are typically regressive, because rich people spend a smaller proportion of their income than poor people do. Unless we specifically want to disincentivize buying things (and a depression is not the time to do that!), I don’t see why we would want to switch to a sales tax.

At the end of the paper Stiglitz talks about the vital difference between short-term spending cuts and long-term fiscal sustainability:

“Thus, policies that promote output and employment today also contribute to future growth – particularly if they lead to more investment. Thus, austerity measures that take the form of cutbacks in spending on infrastructure, technology, or education not only weaken the economy today, but weaken it in the future, both directly (through the obvious impacts, for example, on the capital stock) but also indirectly, through the diminution in human capital that arises out of employment or educational experience. […] Mindless “deficit fetishism” is likely to be counterproductive. It will weaken the economy and prove counterproductive to raising revenues because the main reason that we are in our current fiscal position is the weak economy.”

It amazes me how many people fail to grasp this. No one would say that paying for college is fiscally irresponsible, because we know that all that student debt will be repaid by your increased productivity and income later on; yet somehow people still think that government subsidies for education are fiscally irresponsible. No one would say that it is a waste of money for a research lab to buy new equipment in order to have a better chance at making new discoveries, yet somehow people still think it is a waste of money for the government to fund research. The most legitimate form of this argument is “crowding-out”, the notion that the increased government spending will be matched by an equal or greater decrease in private spending; but the evidence shows that many public goods—like education, research, and infrastructure—are currently underfunded, and if there is any crowding-out, it is much smaller than the gain produced by the government investment. Crowding-out is theoretically possible but empirically rare.

Above all, now is not the time to fret about deficits. Now is the time to fret about unemployment. We need to get more people working; we need to create jobs for those who are already seeking them, better jobs for those who have them but want more, and opportunities for people who have given up searching for work to keep trying. To do that, we need spending, and we will probably need deficits. That’s all right; once the economy is restored to full capacity then we can adjust our spending to balance the budget (or we may not even need to, if we devise taxes correctly).

Of course, I fear that most of these policies will fall upon deaf ears; but Stiglitz calls us to action:

“We can reform our tax system in ways that will strengthen the economy today, address current economic and social problems, and strengthen our economy for the future. The economic agenda is clear. The question is, will the vested interests which have played such a large role in creating the current distorted system continue to prevail? Do we have the political will to create a tax system that is fair and serves the interests of all Americans?”

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.