Fiscal Cliffs, Debt Limits, and Unsustainable Deficits: Can the US Really Run Out of Dollars?

L. RANDALL WRAY, LEVY INSTITUTE & UMKC WRAYR@UMKC.EDU WWW.LEVY.ORG WWW.ECONOMONITOR.COM/LRWRAY/

Fiscal Constraints
President Obama: Government is running out of money!

Economists: Unsustainable debt path!

70% of Americans say progress on Deficit needed this year

Chinese might stop lending to us! Zimbabwe and Weimar hyperinflation! Burden our grandkids!

Look at Euroland!
Sovereign debt crisis Default risk Bond vigilantes

But Is that True?

It aint what you dont know that gets you into trouble. Its what you know for sure that just aint so. Mark Twain

First lets look at the data

Debt Limits, Fiscal Cliff, Sequestration

Debt limit imposed century ago 2011 Budget Control Act created Fiscal Cliff to hit Jan 1, 2013
postponed until March; compromise increased payroll tax

Sequestration: $1.2 trillion in cuts

$600B domestic (Air Traffic, Headstart) $600B military Reduce GDP 1% directly, and multiplier

Is there evidence of run-away, Weimar/Zimbabwe Deficit Spending? Is debt at historic high? Is govt spending out of control? Have we hocked ourselves to China? Does debt burden our grandkids? Will Entitlements bankrupt our grandkids?

Federal Government Receipts and Expenditures (QoQ Change)

25

20 15 10 5
0

Transfer Payments

-5
-10

Consumption Expenditures

-15 -20
-25

Tax Receipts
2005-IV 2005-II 2005-III

-30

Source: Bureau of Economic Analysis and Authors' Calculations

2009-IV

2006-IV

2007-IV

2008-IV

2006-II

2007-II

2008-II

2006-III

2007-III

2008-III

2009-II

2007-I

2009-III

2006-I

2008-I

2009-I

2010-II

2005-I

2010-I

Foregin Holdings of US Treasuries (% of total held by Foreign Countries)

80 70 60 50 40 30 UK 20 10 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 China Japan Brazil Taiw an Hong Kong Caribbean Banking Centers Oil Exporters Germany

Source: US Department of Treasury, November 2009 figures Note: For some years the holdings of the selected countries have been insignificant, so they are included in the category

Treasury Security Holdings (% of Total Oustanding)

60 50 40
%

30 20 10
2009 Q3 2010 Q1

0
1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

7 6 5 4 3 2 1 0 -1 -2

Held by Rest of the World Foreign Official Holdings Foreign Private Holdings Financial Sector Holdings Current Account Balance (Sign Reversed)*

Source: US Flow of Funds Accounts (for Treasury Holdings) and Bureau of Economic Analysis (for Current Account data) *Current account data is as of the end of 2009; treasury holdings data is as of 2009 Q3

But What About the Long Run?

Budget deficit already falling as tax revenues recover Some claim the problem is not with the current situation, but with entitlements
We face chronic Budget Deficits and rising Debt for decades Infinite Horizon forecasts: Tens of trillions of dollars of unfunded commitments

Remember Clinton and Goldilocks?

1996: US Federal Govt begins to run surpluses; continued for 2.5 years Clinton projects surpluses for next 15 years All Govt debt will be retired But: Private debt explodes and then recession restores deficits. Why: The Meaning of Zero:
0=Private Bal + Govt Bal + Foreign Bal

THE CONCEPTUAL FRAMEWORK

Accounting Identity of Financial Balances

PRIVATE SECTOR BALANCE + GOVERNMENT BALANCE = CURRENT ACCOUNT BALANCE

INTERNAL FINANCIAL BALANCE

EXTERNAL FINANCIAL BALANCE

Purported Unsustainability of Government Deficits and Debt

Sustainability issues
Relation between interest rates and economic growth: If r>g growth of debt Growth of Debt Bond Vigilantes push up r accelerating the rise of debt ratios Excessive Deficit-to-GDP and Debt-to-GDP ratios: inflation and ultimately insolvency
So: We must show: a) why govt doesnt face insolvency, and b) why deficits dont raise interest rates

St. Louis Fed

"As the sole manufacturer of dollars, whose debt is denominated in dollars, the U.S. government can never become insolvent, i.e., unable to pay its bills. In this sense, the government is not dependent on credit markets to remain operational. Moreover, there will always be a market for U.S. government debt at home because the U.S. government has the only means of creating risk-free dollar-denominated assets. Government can NEVER run out of Dollars; It can NEVER be forced to default; It can NEVER be forced to miss a payment; It is NEVER subject to whims of bond vigilantes.

Let That Cat Out of the Bag!

Lord Adair Turner, Chairman of the FSA: within limits financing government spending by printing money absolutely, definitively does not lead to inflation.

I accept entirely that this is a very dangerous thing to let out of the bag, that this is a medicine in small quantities but a poison in large quantities but that there exist some circumstances, in which it is appropriate to take that risk.

Myths, Superstition, Old-Time Religion

"I think there is an element of truth in the superstition that the budget must be balanced at all times. Once it is debunked [that] takes away one of the bulwarks that every society must have against expenditure out of control. There must be discipline in the allocation of resources or you will have anarchistic chaos and inefficiency. And one of the functions of old fashioned religion was to scare people by sometimes what might be regarded as myths into behaving in a way that the long-run civilized life requires. (Samuelson) Necessity of balancing the budget is a myth, a superstition, the equivalent of that old-time religion. So what is the truth? If economics is to rise above superstition, we need to know.

How Government Spends its Own Currency: Keystrokes

Spending credits
Government credits banks reserves; bank credits

account of recipient
Taxes debits

Government debits banks reserves; bank debits

account of taxpayer
Deficits net credits

Government net credits banks reserves; bank net

credits account of recipient

Money as Scorekeeping

Bond Sales by Government: Why the Bond Vigilantes Cannot Dictate Terms
Deficit spending net credits reserves Creates Net Financial Wealth in nongovt sector

Excess Reserves bid overnight rate down

To Feds support rate (fed funds rate) Bonds: Interest earning alternative (IRMA)

Part of Monetary Policy, whether new issues or open

market sales Changes form of Net Financial Wealth (longer maturity) (NB: Surpluses net debits OMP or Redemptions)

Self-imposed constraints
Budgeting, debt limits

Operational constraints:
Treasury writes checks on accounts at CB CB prohibited from buying Treasury Debt new issues Use of Special Depositories Use of Tax and Loan accts

Central Bank Policy

Consensus: central banks always operate on overnight

interest rate
Accommodates Demand for Reserves

Convertible vs. non-convertible currencies

Convertible: can lose control of interest rate (Greece)

Nonconvertible: controls overnight rate (Japan)

Sovereign Currency: Summary

Deficit spending creates private financial wealth
Note that CB operations do not; it buys government bonds or

lends against collateral (helicopter drop is fiscal policy) CB Lends; Treasury Spends
Doesnt matter whether bonds must be sold firstso long as

CB accommodates reserve demand

Doesnt matter whether CB prohibited from buying new

issuesroundabout through banks

Doesnt matter whether Treasury must have money in its

acct at CB to spendCB and banks cooperate

Principles of Functional Finance (Abba Lerner)

i. Government should spend more if there is

unemployment ii. Government should supply more money (reserves) if interest rates are too high NB: Budgetary outcome, Debt outcome should never be primary consideration

Friedman or Keynes?
Let us suppose that one day a helicopter flies over this community and drops an additional $1000 in bills from the sky, which is, of course, hastily collected by members of the community Milton Friedman, Optimal Quantity of Money If the Treasury were to fill old bottles with bank notes, bury them at suitable depths in disused coal mines and leave it to private enterprise on tried principles of laissez faire to dig the notes up again there need be no more unemployment and the real income of the country would then become a good deal greater than it actually is. JM Keynes, The General Theory

Friedman or Keynes?
Martin Wolfe, FT: In the present exceptional circumstances, when expanding private credit and spending is so hard, if not downright dangerous, the case for using the states power to create credit and money in support of public spending is strong. Adair Turner: Japan should have done some outright monetary financing over the last 20 years, and if it had done so would now have a higher nominal gross domestic product, some combination of a higher price level and a higher real output level, and a lower debt to gross domestic product ratio.

Japan: a scary precedent?

Japan: rapid growth in 1980s, with highest budget deficits in developed world Massive real estate boom in late 1980s Govt Budget moved to surplus Economy collapsed; 20 years of recession, deflation, falling real estate prices Relies on zero interest rates and massive XR (QE)

EURO: Non-Sovereign Currency

Member states gave up own sovereign currencies

Adopted a foreign currency, the Euro

Much like a USA state: a user of the currency, not issuer Constrained in its spending: tax revenue, bond sales,

willingness of ECB to lend

Problem: no fiscal equivalent to Uncle Sam in Washington

Euro is the Problem

By adopting the euro sovereign nations have turned into something like U.S. states. Unlike U.S. states euro governments have to fund pensions and healthcare Euro governments had to deal with banking problems in the U.S. the Fed did the bailing out.
U.S. States Debt/GDP Ratios (Average 1997-2008)
Alaska Connecticut Hawaii 15.7 12.1 12.2 Montana New Hampshire New York 12.2 13.0 10.5

Maine Massachusetts

11.0 16.5

Rhode Island Vermont

16.9 12.6

Conclusions
Currency-issuing Government spends by

crediting bank accts, taxes by debiting Can always afford to spend more
Issues: inflation, exchange rate effects, interest rate

effects
Sovereign currency gives more policy space No default risk Can control interest rates Can use policy to achieve full employment

What I did and did NOT say

I did say: Sovereign Government faces no financial constraints;

cannot become insolvent in its own nonconvertible currency

But it can only buy what is for sale

I did NOT say that Government ought to buy everything for sale
Size of Government is a political decision with economic

effects
I did NOT say that deficits cannot be inflationary:

Deficits that are too big can cause inflation

I did NOT say that deficits cannot affect exchange rates:

Sovereign Governments let currency float; float means

currency can go up and down

Thank you
L. Randall Wray Professor of Economics, UMKC Senior Scholar, Levy Economics Institute wrayr@umkc.edu www.levy.org
W W W . E C O N O M O N I T O R . C O M / L R W R AY /