interest rates

Is the cure for inflation worse than the disease?

pnrj current events, macroeconomics, politics, public policy , , , , , , , , , , ,

Nov 13 JDN 2459897

A lot of people seem really upset about inflation. I’ve previously discussed why this is a bit weird; inflation really just isn’t that bad. In fact, I am increasingly concerned that the usual methods for fixing inflation are considerably worse than inflation itself.

To be clear, I’m not talking about hyperinflation—if you are getting triple-digit inflation or more, you are clearly printing too much money and you need to stop. And there are places in the world where this happens.

But what about just regular, ordinary inflation, even when it’s fairly high? Prices rising at 8% or 9% or even 11% per year? What catastrophe befalls our society when this happens?

Okay, sure, if we could snap our fingers and make prices all stable without cost, that would be worth doing. But we can’t. All of our mechanisms for reducing inflation come with costs—and often very high costs.

The chief mechanism by which inflation is currently controlled is open-market operations by central banks such as the Federal Reserve, the Bank of England, and the European Central Bank. These central banks try to reduce inflation by selling bonds, which lowers the price of bonds and reduces capital available to banks, and thereby increases interest rates. This also effectively removes money from the economy, as banks are using that money to buy bonds instead of lending it out. (It is chiefly in this odd indirect sense that the central bank manages the “money supply”.)

But how does this actually reduce inflation? It’s remarkably indirect. It’s actually the higher interest rates which prevent people from buying houses and prevent companies from hiring workers which result in reduced economic growth—or even economic recession—which then is supposed to bring down prices. There’s actually a lot we still don’t know about how this works or how long it should be expected to take. What we do know is that the pain hits quickly and the benefits arise only months or even years later.

As Krugman has rightfully pointed out, the worst pain of the 1970s was not the double-digit inflation; it was the recessions that Paul Volcker’s economic policy triggered in response to that inflation. The inflation wasn’t exactly a good thing; but for most people, the cure was much worse than the disease.

Most laypeople seem to think that prices somehow go up without wages going up, but that simply isn’t how it works. Prices and wages rise at close to the same rate in most countries most of the time. In fact, inflation is often driven chiefly by rising wages rather than the other way around. There are often lags between when the inflation hits and when people see their wages rise; but these lags can actually be in either direction—inflation first or wages first—and for moderate amounts of inflation they are clearly less harmful than the high rates of unemployment that we would get if we fought inflation more aggressively with monetary policy.

Economists are also notoriously vague about exactly how they expect the central bank to reduce inflation. They use complex jargon or broad euphemisms. But when they do actually come out and say they want to reduce wages, it tends to outrage people. Well, that’s one of three main ways that interest rates actually reduce inflation: They reduce wages, they cause unemployment, or they stop people from buying houses. That’s pretty much all that central banks can do.

There may be other ways to reduce inflation, like windfall profits taxes, antitrust action, or even price controls. The first two are basically no-brainers; we should always be taxing windfall profits (if they really are due to a windfall outside a corporation’s control, there’s no incentive to distort), and we should absolutely be increasing antitrust action (why did we reduce it in the first place?). Price controls are riskier—they really do create shortages—but then again, is that really worse than lower wages or unemployment? Because the usual strategy involves lower wages and unemployment.

It’s a little ironic: The people who are usually all about laissez-faire are the ones who panic about inflation and want the government to take drastic action; meanwhile, I’m usually in favor of government intervention, but when it comes to moderate inflation, I think maybe we should just let it be.

What does a central bank actually do?

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Aug 26 JDN 2458357

Though central banks are a cornerstone of the modern financial system, I don’t think most people have a clear understanding of how they actually function. (I think this may be by design; there are many ways we could make central banking more transparent, but policymakers seem reluctant to show their hand.)

I’ve even seen famous economists make really severe errors in their understanding of monetary policy, as John Taylor did when he characterized low-interest-rate policy as a “price ceiling”.

Central banks “print money” and “set interest rates”. But how exactly do they do these things, and what on Earth do they have to do with each other?

The first thing to understand is that most central banks don’t actually print money. In the US, cash is actually printed by the Department of the Treasury. But cash is only a small part of the money in circulation. The monetary base consists of cash in vaults and in circulation; the US monetary base is about $3.6 trillion. The money supply can be measured a few different ways, but the standard way is to include checking accounts, traveler’s checks, savings accounts, money market accounts, short-term certified deposits, and basically anything that can be easily withdrawn and spent as money. This is called the M2 money supply, and in the US it is currently over $14.1 trillion. That means that only 25% of our money supply is in actual, physical cash—the rest is all digital. This is actually a relatively high proportion for actual cash, as the monetary base was greatly increased in response to the Great Recession. When we say that the Fed “prints money”, what we really mean is that they are increasing the money supply—but typically they do so in a way that involves little if any actual printing of cash.

The second thing to understand is that central banks don’t exactly set interest rates either. They target interest rates. What’s the difference, you ask?

Well, setting interest rates would mean that they made a law or something saying you have to charge exactly 2.7%, and you get fined or something if you don’t do that.

Targeting interest rates is a subtler art. The Federal Reserve decides what interest rates they want banks to charge, and then they engage in what are called open-market operations to try to make that happen. Banks hold reserves—money that they are required to keep as collateral for their loans. Since we are in a fractional-reserve system, they are allowed to keep only a certain proportion (usually about 10%). In open-market operations, the Fed buys and sells assets (usually US Treasury bonds) in order to either increase or decrease the amount of reserves available to banks, to try to get them to lend to each other at the targeted interest rates.

Why not simply set the interest rate by law? Because then it wouldn’t be the market-clearing interest rate. There would be shortages or gluts of assets.

It might be easier to grasp this if we step away from money for a moment and just think about the market for some other good, like televisions.

Suppose that the government wants to set the price of a television in the market to a particular value, say $500. (Why? Who knows. Let’s just run with it for a minute.)

If they simply declared by law that the price of a television must be $500, here’s what would happen: Either that would be too low, in which case there would be a shortage of televisions as demand exceeded supply; or that would be too high, in which case there would be a glut of televisions as supply exceeded demand. Only if they got spectacularly lucky and the market price already was $500 per television would they not have to worry about such things (and then, why bother?).

But suppose the government had the power to create and destroy televisions virtually at will with minimal cost.
Now, they have a better way; they can target the price of a television, and buy and sell televisions as needed to bring the market price to that target. If the price is too low, the government can buy and destroy a lot of televisions, to bring the price up. If the price is too high, the government can make and sell a lot of televisions, to bring the price down.

Now, let’s go back to money. This power to create and destroy at will is hard to believe for televisions, but absolutely true for money. The government can create and destroy almost any amount of money at will—they are limited only by the very inflation and deflation the central bank is trying to affect.

This allows central banks to intervene in the market without creating shortages or gluts; even though they are effectively controlling the interest rate, they are doing so in a way that avoids having a lot of banks wanting to take loans they can’t get or wanting to give loans they can’t find anyone to take.

The goal of all this manipulation is ultimately to reduce inflation and unemployment. Unfortunately it’s basically impossible to eliminate both simultaneously; the Phillips curve describes the relationship generally found that decreased inflation usually comes with increased unemployment and vice-versa. But the basic idea is that we set reasonable targets for each (usually about 2% inflation and 5% unemployment; frankly I’d prefer we swap the two, which was more or less what we did in the 1950s), and then if inflation is too high we raise interest rate targets, while if unemployment is too high we lower interest rate targets.

What if they’re both too high? Then we’re in trouble. This has happened; it is called stagflation. The money supply isn’t the other thing affecting inflation and unemployment, and sometimes we get hit with a bad shock that makes both of them high at once. In that situation, there isn’t much that monetary policy can do; we need to find other solutions.

But how does targeting interest rates lead to inflation? To be quite honest, we don’t actually know.

The basic idea is that lower interest rates should lead to more borrowing, which leads to more spending, which leads to more inflation. But beyond that, we don’t actually understand how interest rates translate into prices—this is the so-called transmission mechanism, which remains an unsolved problem in macroeconomics. Based on the empirical data, I lean toward the view that the mechanism is primarily via housing prices; lower interest rates lead to more mortgages, which raises the price of real estate, which raises the price of everything else. This also makes sense theoretically, as real estate consists of large, illiquid assets for which the long-term interest rate is very important. Your decision to buy an apple or even a television is probably not greatly affected by interest rates—but your decision to buy a house surely is.

If that is indeed the case, it’s worth thinking about whether this is really the right way to intervene on inflation and unemployment. High housing prices are an international crisis; maybe we need to be looking at ways to decrease unemployment without affecting housing prices. But that is a tale for another time.

Thus ends our zero-lower-bound interest rate policy

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JDN 2457383

Not with a bang, but with a whimper.

If you are reading the blogs as they are officially published, it will have been over a week since the Federal Reserve ended its policy of zero interest rates. (If you are reading this as a Patreon Blog from the Future, it will only have been a few days.)

The official announcement was made on December 16. The Federal Funds Target Rate will be raised from 0%-0.25% to 0.25%-0.5%. That one-quarter percentage point—itself no larger than the margin of error the Fed allots itself—will make all the difference.

As pointed out in the New York Times, this is the first time nominal interest rates have been raised in almost a decade. But the Fed had been promising it for some time, and thus a major reason they did it was to preserve their own credibility. They also say they think inflation is about to hit the 2% target, though it hasn’t yet (and I was never clear on why 2% was the target in the first place).

Actually, overall inflation is currently near zero. What is at 2% is what’s called “core inflation”, which excludes particularly volatile products such as oil and food. The idea is that we want to set monetary policy based upon long-run trends in the economy as a whole, not based upon sudden dips and surges in oil prices. But right now we are in the very odd scenario of the Fed raising interest rates in order to stop inflation even as the total amount most people need to spend to maintain their standard of living is the same as it was a year ago.

As MSNBC argues, it is essentially an announcement that the Second Depression is over and the economy has now returned to normal. Of course, simply announcing such a thing does not make it true.

Personally, I think this move is largely symbolic. The difference between 0% and 0.25% is unimportant for most practical purposes.

If you owe $100,000 over 30 years at 0% interest, you will pay $277.78 per month, totaling of course $100,000. If your interest rate were raised to 0.25% interest, you would instead owe $288.35 per month, totaling $103,807.28. Even over 30 years, that 0.25% interest raises your total expenditure by less than 4%.

Over shorter terms it’s even less important. If you owe $20,000 over 5 years at 0% interest, you will pay $333.33 per month totaling $20,000. At 0.25%, you would pay $335.46 per month totaling $20,127.34, a mere 0.6% more.

Moreover, if a bank was willing to take out a loan at 0%, they’ll probably still be at 0.25%.

Where it would have the largest impact is in more exotic financial instruments, like zero-amortization or negative-amortization bonds. A zero-amortization bond at 0% is literally free money forever (assuming you can keep rolling it over). A zero-amortization bond at 0.25% means you must at least pay 0.25% of the money back each year. A negative-amortization bond at 0% makes no sense mathematically (somehow you pay back less than 0% at each payment?), while a negative-amortization bond at 0.25% only doesn’t make sense practically. If both zero and negative-amortization seem really bizarre and impossible to justify, that’s because they are. They should not exist. Most exotic financial instruments have no reason to exist, aside from the fact that they can be used to bamboozle people into giving money to the financial corporations that create them. (Which reminds me, I need to see The Big Short. But of course I have to see Star Wars: The Force Awakens first; one must have priorities.)

So, what will happen as a result of this change in interest rates? Probably not much. Inflation might go down a little—which means we might have overall deflation, and that would be bad—and the rate of increase in credit might drop slightly. In the worst-case scenario, unemployment starts to rise again, the Fed realizes their mistake, and interest rates will be dropped back to zero.

I think it’s more instructive to look at why they did this—the symbolic significance behind it.

The zero lower bound is weird. It makes a lot of economists very uncomfortable. The usual rules for how monetary and fiscal policy work break down, because the equation hits up against a constraint—a corner solution, more technically. Krugman often talks about how many of the usual ideas about how interest rates and government spending work collapse at the zero-lower-bound. We have models of this sort of thing that are pretty good, but they’re weird and counter-intuitive, so policymakers never seem to actually use them.

What is the zero lower bound, you ask? Exactly what it says on the tin. There is a lower bound on how low you can set an interest rate, and for all practical purposes that limit is zero. If you start trying to set an interest rate of -5%, people won’t be willing to loan out money and will instead hoard cash. (Interestingly, a central bank with a strong currency, such as that of the US, UK, or EU, can actually set small negative nominal interest rates—because people consider their bonds safer than cash, so they’ll pay for the safety. The ECB, Europe’s Fed, actually did so for awhile.)

The zero-lower-bound actually applies to prices in general, not just interest rates. If a product is so worthless to you that you don’t even want it if it’s free, it’s very rare for anyone to actually pay you to take it—partly because there might be nothing to stop you from taking a huge amount of it and forcing them to pay you ridiculous amounts of money. “How much is this paperclip?” “-$0.75.” “I’ll have 50 billion, please.” In a few rare cases, they might be able to pay you to take it an amount that’s less than what it costs you to store and transport. Also, if they benefit from giving it to you, companies will give you things for free—think ads and free samples. But basically, if people won’t even take something for free, that thing simply doesn’t get sold.

But if we are in a recession, we really don’t want loans to stop being made altogether. So if people are unwilling to take out loans at 0% interest, we’re in trouble. Generally what we have to do is rely on inflation to reduce the real value of money over time, thus creating a real interest rate that’s negative even though the nominal interest rate remains stuck at 0%. But what if inflation is very low? Then there’s nothing you can do except find a way to raise inflation or increase demand for credit. This means relying upon unconventional methods like quantitative easing (trying to cause inflation), or preferably using fiscal policy to spend a bunch of money and thereby increase demand for credit.

What the Fed is basically trying to do here is say that we are no longer in that bad situation. We can now set interest rates where they actually belong, rather than forcing them as low as they’ll go and hoping inflation will make up the difference.

It’s actually similar to how if you take a test and score 100%, there’s no way of knowing whether you just barely got 100%, or if you would have still done as well if the test were twice as hard—but if you score 99%, you actually scored 99% and would have done worse if the test were harder. In the former case you were up against a constraint; in the latter it’s your actual value. The Fed is essentially announcing that we really want interest rates near 0%, as opposed to being bound at 0%—and the way they do that is by setting a target just slightly above 0%.

So far, there doesn’t seem to have been much effect on markets. And frankly, that’s just what I’d expect.

Fear not the deficit

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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.