All that Bunk About Deficits and Skyrocketing Interest Rates

It is astounding how long experts can keep repeating the conventional wisdom in the face of -what SHOULD be – overwhelming reality.  The way things work today, the Federal Reserve sets the interest rate.  Additionally, inflation is determined primarily by aggregate demand.  We have nearly 5 years of data backing this stuff up.  Yet, the conventional wisdom marches on.

The federal reserve very plainly sets the (short-term) interest rate.  That is what they do.  It’s called an Open Market Operation. When they want interests to go down they buy U.S. bonds.  That puts cash in the system and lowers interest rates.  When the Fed wants interest rates to go up, they sell their stock of U.S. bonds and remove cash from the system.  In this way the federal reserve sets the interest rate on U.S. bonds which then in turn influence other interest rates(like mortgages and car loans).  This isn’t a secret.  They explain it on their website.

Despite this, we have deficit terrorists running around telling us that we need to cut social security and gut medicare right now! This very instant!  Because if we don’t, interest rates will spike.  We’ll have to start paying 150 bazillian% (Note:  not a real number) on the federal debt and our mortgages.  Pete Peterson, the stereotypical deficit terrorist, states the conventional wisdom very plainly.

I see two potential crises in the future: a near-term financial crisis rooted in declining investor confidence that leads to sharp rises in interest rates and forces sudden, draconian changes in the federal budget; and a longer-term economic crisis that would result from diverting more and more of our national resources to servicing debt instead of investing in areas that are essential to long-term growth. These crises are made all the more likely by the fact that growing debts aren’t just an American problem. Projections show that, by 2035, the world’s advanced economies could face debts approaching 200% of their GDP. With countries competing for scarce capital, interest rates are almost sure to rise steeply.

(emphasis added)

We are now on fiscal year 5 of approx trillion-dollar budget deficits.  I’m still waiting on those mythical bond vigilantes to spike our interest rates.

With that in mind, I found two news stories that are oh-so interesting.  The first is that Mortgage rates hit a new record low last week.  So much for worrying about skyrocketing interest rates…  But what about U.S. bonds?   Maybe those are skyrocketing?  They are still insanely low.  On top of that, there was a bond auction this week where, for every 1$ in U.S. treasuries being sold, 3.16$ was bidding to buy them.  That is a record high amount of bids.  So despite low interest rates and high budget deficits, bond holders are not only sticking with U.S. bonds, but are flocking towards them in record numbers.

In both cases, it is because the federal reserve is purposely keeping the interest rates low.  They always keep it low when they want it low and always keep it high when they want it high.  At this point, I expect someone who is well-versed in the conventional wisdom to grab his or her hair and shout, “Fed keeping interest rates low?  zOMG!  Hyperinflation!  Weimer!  Printing Press!”, and then their head explodes(Note:  I cannot be held liable for exploding heads).  All I have to say is that I am still waiting on that hyperinflation.

The small, but growing community of Modern Monetary Theory(MMT) economists can explain this phenomenon better than conventional economists.  They understand how Modern money works.  How Inflation an interest rates are really set.  Unfortunately, the conventional wisdom doesn’t want to hear it.  Instead, we continue to have both presidential nominees talk about budget deficits without anyone asking to explain the supposed problem.

Inflation Chicken Little Bill Fleckenstein

I read an article on MSN yesterday from February 3rd  about how we’re at the “inflection point” where all that “quantitative easing” the Fed has been doing is going to start causing inflation.

And, if we are finally at that inflection point, the world will then slowly begin to concern itself with stagflation and inflation, and eventually the world’s bond market participants will start to demand more in interest-rate compensation due to real rates being negative, which will shut down the central bankers’ printing presses. No one will accept negative real rates and just getting their money back if they are no longer worried about a deflationary collapse.

In sum, I believe we are approaching (if not at) that inflection point and that deflation is about to become very old news until sometime down the road, potentially when the printing press is taken away from the central banks.

Wow!  Buckle in everybody, that inflation-stagflation is finally coming.  Bill Fleckenstein, noted investor has called it.  Just out of curiosity, I checked some of Bill’s past predictive calls and found it enlightening.

Back in January, a month before this article, Bill predicted inflation and a gold rally.

The month before that  in December he made the following prediction:

Eventually, as fear of default fades — and investors demand a return on their capital, not just return of their capital — the bond markets will take the printing press away from the central bankers because of inflation and currency debasement.

I’ll skip over another dozen articles where he complains about so-called money printing and go all the way back to February 2011, “Ben Bernanke seems to have won his imaginary battle with deflation, but he (like many others) seems oblivious to the real threat of inflation.

Back in late 2010 he predicted growing interest rates in 2011 because of all that “money-printing” and to expect lots of inflation.

His oldest article available on MSN was from September 03, 2010 and guess what?  In it he predicts inflation!

As I said two weeks ago, I believe it is more likely that we are in for a period of stagflation, which is an entirely different world from deflation. With stagflation, interest rates eventually rise, and bonds do poorly. Companies benefit when they have pricing power and barriers to entry that keep potential competitors away, as do companies that are growing rapidly.

Unfortunately I can’t go back to 2009 because his articles aren’t available.  However, I found 2 blog posts from 2009 each referencing a different Fleckenstein article in which he was warning people about coming inflation.  See here and here.

Since this guy has been warning us about coming inflation for at least 3 1/2 years, I’m going to take his latest warning with a grain of salt.

With all the extra demand the government has been pumping into the economy, eventually it is eventually going to heal, start growing, and may someday start causing inflation, but at over 8% unemployment and a federal government that keeps threatening austerity and deficit reductions(thankfully it’s only half-a*** these things), that day is not near.  If and when it does happen, then we can start following their austerity advice.

Still waiting on that hyperinflation.

In 2009, there was a crazy, wild-eyed passion spreading among conservatives and the Teabagger.  Here are some choice quotes from prominent conservatives and teabagger favorites.

Glenn Beck and Ron Paul

Ron Paul:  [snip] So the bailout is a disease, it’s contagious, it’s ongoing, and the result of this will be the destruction of the dollar, which to me means runaway inflation, and political chaos. It’s very, very dangerous.

Glenn Beck: OK, hang on, because you are saying “runaway inflation”. You’re meaning Weimar Republic, wheelbarrow full of money type of stuff to buy a loaf of bread. Is that the kind of inflation you are talking about?

Eric Cantor

Finally, we must ensure that vast government spending doesn’t lead to rampant inflation in the future. At $825 billion, this Democrat stimulus proposal causes us great concern. While the Fed remains rightfully concentrated on fighting deflation, uncontrolled spending and borrowing will most ultimately lead to inflation if the spigot is not turned off in time. That could trigger a flight of foreign capital and a steep drop in the purchasing power of the dollar for the American consumer. As interests rates rise to keep foreigners financing our debt, the pain dealt to businesses and families alike promises to be sharp.

Michele Bachman

Make no mistake. This stimulus bill has very little to do with stimulating the economy and helping the average American . This is a bailout for big government. And let’s get ready. We are looking at massive tax increases and we are looking at massive inflation or both. In fact, we could be looking at hyperinflation.

Arthur Laffer (The “Father of supply-side economics” or Reaganomics)

With the crisis, the ill-conceived government reactions, and the ensuing economic downturn, the unfunded liabilities of federal programs — such as Social Security, civil-service and military pensions, the Pension Benefit Guarantee Corporation, Medicare and Medicaid — are over the $100 trillion mark. With U.S. GDP and federal tax receipts at about $14 trillion and $2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and partial default on government promises.

But as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.

We are a couple of months away from the close of the third year of the Obama Administration.  Before that we will mark the 4 year anniversary of the start of the Great Recession(Dec 2007).  And, most importantly we’ve just finished our third fiscal year in a row of having more than a trillion-dollar budget deficit.

So based on all the hyperbole of conservatives, and the fact we’ve had such huge budget deficits, one might think we were facing huge bouts of inflation.  So let’s take a look at the inflation rate for the last three years.
As you can see, since the stimulus and other government spending brought us out of a recession, month to month changes bounced around between .4 and negative .2 and only briefly went higher than .5 percent.  However, is that a lot?  Let’s compare it to the previous years.  Let’s take at the data since January 2001.




As you can see, after officially exiting the recession, inflation has actually been consistently lower than in the earlier, non-recession ,years.  The only spike you see was from earlier this year and was almost entirely driven by energy costs.  How do I know?  Let’s lay over the cost of energy in general and gasoline into the graphs.




Remember these are month-to-month changes.  As you can see, the energy costs went up so much higher and faster that I had to adjust the scale of the graph to show the increase.  General Prices(blue line) barely looks like a bump while Gas Prices(Red) and general energy costs(Green) went up about 10 times as fast.  So those price increases weren’t driven by general inflation, they were driven by an increase in energy costs.

So in spite of these billion and trillion-dollar budget deficits, how has there been such low inflation?  Didn’t Weimer Germany prove that always happens?  The assumption that a large budget deficits will automatically lead to high inflation is deeply ingrained in our politics.  Based on the last 3 years, you would think that this belief would be re-examined.   And yet, republicans and conservative allies are still warning that the sky is falling inflation is coming.  The whole theory of oncoming inflation is based on the flawed quantity theory of money.  A theory rendered even less relevant since it was developed when we were still on a gold standard.

So what is an alternative explanation?  Does this mean that government can spend and spend without consequence?  MMT (which evolved from keynesian economics) provides an alternative economic framework for understanding why a government can have a trillion dollar deficit 3 years running and still have inflation that is lower than it was when deficits were less than 400 billion.  First of all, inflation comes from spending money, not creating it.

As long as all spending is matched by an equal increase in the amount of goods and services produced by an economy, that spending won’t be inflationary.  Here’s the macro economic implications:  During a recession dollar savings tends to increase – i.e. people tend not to spend their money.  People are afraid of losing their job, and businesses are afraid to expand, leading to reinforcing recessionary effects. One thing that doesn’t change right away is the capacity in the economy. Therefore, when people save dollars, they open up room for the federal government to deficit spend money that won’t be inflationary.  In fact, if the government doesn’t spend it’ll cause deflation which is really bad for an economy.

To better understand the macro economics, let’s take a look at a micro economic example:  Presumably, even during a recession, a factory that produced 100 cars yesterday, can still produce 100 today.  If all the people in the economy bought 100 cars yesterday, but only bought 99 today, then that means that the government can come in and buy an extra car and it won’t be inflationary because the factory can produce it.  Now, of course I’m not suggesting that the government start asking factories how much it can produce and directly buy what it doesn’t sell.  Instead, I’m just trying to give a micro example of what is happening across an entire economy.  The economy has excess capacity that the people producing the items aren’t buying because they are saving their dollars.

The take away is that the federal government has the ability to have deficits until the economy can no longer increase the amount of goods the economy is capable of producing, then inflation happens.  The size the budget deficit can be depends on many things.  One of the things as explained above is the rate of private savings which tends to be higher during recessions.  That is why the federal government can run a trillion dollar plus deficit 3 years running and the economy can still have a lower inflation rate than when it was running sub 400 billion dollar deficit.

Job Guarantee: Zero Unemployment Without Causing Inflation

Once when I was explaining Modern Monetary Theory(MMT) to someone in person, she asked me in a very irritated tone, “what is your point?” I realize now that getting too far into the details about government spending, trade deficits, and bond markets can make some people’s eyes glaze over without assuring them that the end goal is worth it. So today I’d like to introduce one of the primary policy goals that most economists of the MMT school advocate. You see, once you realize that the federal budget is constrained by inflation, not revenue, that bond vigilantes raising our interest rate isn’t a real thing, and there is no such thing as a crowding out effect, new policy options become available in the fights against unemployment and inflation.

One of the primary policy goes of most MMT economists is a Job Guarantee. Sometimes we’ll refer to it as a Federal Job Guarantee(FJG), Employer of last resort(ELR), Labor Buffer Stock, etc… It’s all basically talking about the same thing, A job guarantee. A job Guarantee would be a permanent job offer from the federal government to all citizens of a certain age for a basic wage to anyone who is ready, willing, and able to work.

The first thing to know is that heading into this discussion you should already understand that the federal government is constrained by inflation, not revenue. The United States, like any country that controls it’s own currency cannot be forced into default. Therefore, we can do “radical” things like setting our own price and letting the market decide quantity. As opposed to setting the quantity we want to purchase and letting the market decide price. That is what a job guarantee does. Instead of asking for x number of workers and letting the market determine how much we pay them, the federal government can say we will pay any worker y wages, and let the market decide how many people will take it. The amount of money spent is irrelevant as long as inflation is controlled.

So how will a Job Guarantee achieve both full employment and price stability? Well, first of all, it will, by definition, eliminate unemployment. Everyone who is ready, willing, and able to work will be able to get a job that is funded by the federal government. That pretty much wipes out unemployment as we currently define it. Of course, there will be some people who refuse the job offer because they’d rather spend time looking for higher paying work. There may be others who refuse to work at the set wage. That’s fine. The program is meant to be completely voluntary.

Now, why won’t something like this be inflationary? Wouldn’t the increased expense of the program increase inflation? The answer is no. Because the program would never demand more labor than is available, it would be impossible for it to cause “demand-pull” inflation. In a recession, employment and aggregate demand decrease which has a deflationary effect. However, with this program in place those workers have the ability to get a job from a job guarantee which would counteract the falling demand. Sure, the increased federal spending could be inflationary, but it’s more than offset by the falling demand caused by the recession.

What about during economic expansions? As the economy recovers people leave the job guarantee program and enter the private workforce for more money. People leaving the program would cause government spending to go down which would cause deflationary pressure, but would be offset by the potential inflationary pressures of a rapidly expanding economy with rising wages.

*poof!* You now have full employment with non-accelerating inflation. You know, when I first started writing this diary, I thought it was going to be long and complicated, but it’s not. It really is so simple that it can be summarized in about 4 paragraphs. Now… time for all the caveats and frequently-asked-questions.

Are you saying there won’t be inflation?
No. I’m not saying that inflation can’t still occur in the economy. There could still be cost-push inflation(like oil prices). There could still be demand-pull inflation if some commodity other than unskilled labor is in short supply. The point is however, we can give everyone a job, without causing accelerating inflation.

One more caveat about inflation. Depending on what we set the “Basic Wage” to be, it could cause a one time hike in prices. If the basic wage is set to be higher than the current minimum wage, then that could cause a 1 time rise in inflation. That’s because whatever the basic wage is will also be the minimum wage. The reason? Most people aren’t going to work for less money in the private sector if the federal government is offering them more. While there might be individual cases where a person may choose to work for less(a “fun” job or with the promise of future pay, like an internship), most will choose the better pay. So, while there might be a one-time rise in prices when the program is put into place, it won’t last and will eventually lead to stability.

If unpaid for, How can it not be inflationary?
This is the last thing I’ll say about inflation. When you add up all the benefits, it’s extremely easy to imagine how A “job guarantee” program could actually be less inflationary than what we currently do with our unemployed workers.

First, There’s the automatic stabilizing effect that I talked about above so I won’t repeat myself.

Second, the unemployed will be working instead of doing nothing. Right now unemployment pays people to not work. The job guarantee puts them to work. Not only them, but the part time “underemployed”, the discouraged workers, and maybe even those who have never worked before. With all these people doing something, even semi-useful, it’s better than doing nothing.

Third, a lot of the cost of the program will be offset by a reduction in spending on other social programs. As it turns out, when people work, they need less government assistance.

Fourth, there will likely be faster movement of workers from the job guarantee to the private sector than under our currently unemployment regime. Even if you don’t believe that SOME(not all, not most, but some) people will take their unemployment until it runs out before getting a new job, you have to recognize that employers are hesitant to hire someone who has been unemployed for a long time. They believe that people lose their “good work habits”. In a job guarantee regime that won’t happen because people will be working.

What programs could be eliminated?
The program is not meant to replace any existing government assistance such as food stamps or medicaid. While many households could be brought out of poverty if only 1 more adult started working full time, it will not work for all households. So while the program might reduce the size of other programs, it will not completely eliminate their function.

Even the concept of unemployment wouldn’t necessarily go away. You would still want people to spend some time looking for a new job before entering the job guarantee program. However, there could be a move to reduce the number of weeks that unemployment is offered. Once anyone can get a job, they won’t need to rely on unemployment checks. Plus, depending on what the basic wage is set too, they would benefit overall by being paid more than what unemployment benefits pay them.

What will these people do?
More often, this question usually comes from conservative leaning people. I guess only a conservative could look around this country and say, “eh, there’s nothing that needs to be done”. However, occasionally a left leaning person will ask the slightly more intelligent question, “with so many unemployed and underemployed are you sure we could find work for everyone? Let me assure you, there is always more work to be done. First, look up everything done by the WPA. If looking at that doesn’t convince, let’s list a few more jobs that almost any worker would have the basic skills that are required.

  • Reading to Children at the library.
  • Library assistant. If they know the alphabet and their numbers, they can haul around books and put them away.
  • Teacher’s assistant: Grading multiple choice tests and making copies
  • Low level aid for elected officials. Every office could use an intern
  • Neighborhood watch. Bunch people into groups and have them patrol neighborhoods and report to police anything they see.
  • Clean and maintain Parks and playgrounds
  • Clean graffiti
  • Pickup litter from the streets
  • Dig trenches to bury electric wires
  • Plant trees along major highways

Those are just jobs for low to unskilled workers. The possibilities are endless if someone shows up for a job that has a particular skill. You could pay musicians to give free performances at local venues, a handyman could repair dilapidated public buildings, child care professionals could open a free or low-cost day care. Better yet, You could pay those with skills to teach those skills, and pay the “unskilled” workers to learn them. I’m not saying that these workers would do all, some, or any of these things. The point is, if you spend 10 minutes thinking about it, there are a lot of things that can be done.

What if somebody never leaves the Job Guarantee program?
So? Seriously, so what? If someone wants to work for minimum wage for the rest of their lives, it isn’t going to hurt you and I one bit. In fact it just means we’ll have a very experienced public worker working for minimum wage, so it would be beneficial to society if this happened. We should thank the individual for not demanding more money and moving to the private sector.

But won’t people [insert scheme to cheat the system]?
There is always the possibility for people to ‘game’ the system. When it happens we’ll just have to be nimble enough to recognize it and correct the problem.

You’ll be replacing existing jobs
This is a strong concern for many. However, I think it’s not a likely scenario. The Job Guarantee “employees” will have a very high turnover rate. Jobs that require a large amount of knowledge and experience could not be replaced by people who may only be there 3 weeks and could quite without a single day’s notice.

How would the program be administered?
There is no strong consensus on how to structure the program. Most MMT economists who want to be apolitical just say, “that’s a political question”. Less cautious individuals give some suggestions. Some advocate it being managed nationally like the WPA. Others think it should be administered by states. Others by non-profits. Those details aren’t as important as buying into the idea of a job guarantee. Once we all can agree on the idea, we can start talking specifics – I have my own thoughts on that topic. The only requirement is that no matter how it’s administered, it must meet the 2 most important criteria: One, everyone can get a job that is ready, willing, and able. Two, the jobs must be completely federally funded.

What will the “Basic Wage” be?
The basic wage should be what a full time employee needs to live. I don’t know what it would be, but I think it should higher than what our current minimum wage is, but that’s just my opinion. Also, the basic wage should not be inflation indexed. Otherwise it’ll spiral upwards and downwards along with the economy instead of providing an anchor for prices. Of course, congress can change the basic wage at any time, but it should not be automatic.

People will be lazy and not work if the job is guaranteed
This is a very common critique. One that has a simple answer. Give whoever is administrating the program the authority to fire people. We can get into the details of how it would work, but just because you are willing to hire anyone who wants a job, doesn’t mean that you can’t also have the ability to fire them. If people don’t show up, or don’t do the work they are assigned – as long as they are capable they can be fired. Depending on how the program is setup you can have other rules like, once fired you can reapply for the job guarantee for a specified amount of time. Other rules would have to be in place to prevent discrimination as well. The point is, there are simple ways to solve the incentive problem without violating the spirit of the job guarantee.

zOMG!  Communism!  USSR!
Communism, you couldn’t be fired.
Communism, you can’t leave the job and join the private sector for better pay.
Communism, you get paid the same as those in other industries.

None of these things apply to the job guarantee.  You can be fired, you get paid the least(so you have every incentive to leave to work in the private sector), and the work is voluntary.  It is only a last resort for people who can’t get work in the private sector.

Finally, I want to say something about the intangible benefits of the program. There will be intangible, nearly impossible to measure benefits to the system as well.
1. Stronger Families. A full time job, even minimum wage job will bring many families out of poverty. Poverty and unemployment has been observed to correlate with kids not doing well in school, and putting strains on marriages.
2. Dignity. Those who depend on the government will have a real chance to have a job and earn the pride that comes with a paycheck.
3. Economic Security. Everyone will know that, worse comes to worse, they can get a government job and at least they can earn enough to feed themselves.

An entire book could be written on a the Job Guarentee so I can’t fit everything into one diary. Other aspects to be explored are comparing it to our current inflation fighting techniques, exactly how it can be structured, and other angles. There will be followup posts on the topic.

Inflation Comes from Spending Money, Not Creating It

A lot of people think that the act of creating money will somehow create inflation all by itself.  That is as ridiculous as saying the mere act of growing more food will solve world hunger(there’s so much more to it).  Inflation is a complicated topic with few absolutes and a lot of misunderstanding.  In this post I want to debunk the myth that just by someone creating money, that it can cause inflation.

First of all, let’s say that the federal government printed off 500 billion dollars in new bills.  You might think that this would automatically create inflation.  But what if the government took all that money, loaded it up into a rocket ship, and sent it to the moon?  Think that would cause inflation?  How about if they took the money and put it in a vault in Fort Knox – do you think that would cause inflation?  No, of course not.  The money was created, but never put into the economy.  If inflation is defined as “too much money chasing too few goods” then the key word most people forget to consider is “chasing”.  Money sitting on the moon or in a vault in Fort Knox aren’t chasing after any goods.

How about some more examples.  For instance, what about the federal government put money in a bank vault.  Would that cause inflation?  Not directly.  Because even though the money has been handed over to someone, it didn’t take any resources out of the economy.  It moved money, but it wasn’t in exchange for anything.  For something to be inflationary it must either add to aggregate demand without adding to equivalent aggregate supply, or take away aggregate supply without removing equivalent aggregate demand.  If the federal government gave dollars to a bank all day everyday, it wouldn’t cause inflation as long as all the bank did with it was to put it in a vault and never spent it or lent it out.  The same thing goes if the federal government gave that 500 billion dollars to a person for free.  Unless that person spends the money, it won’t be inflationary.

Of course, many of the things I’ve described will precede money being spent, and will indirectly cause inflation.  For instance, giving a person money will precede them spending it and causing inflation.  Giving money to a bank will precede them lending it out to someone who will then spend the money.  So while it is often the case doing those things can cause inflation, it’s important to know that the act of creating the money doesn’t necessarily cause the inflation until the money is spent.  Let’s take a look at some real life examples where this distinction becomes important.

If the federal government sent  a hundred dollars to every citizen in the country that would be around 30 billion dollars created.  However, if everyone took that money and stuck it into their savings account, it wouldn’t cause any inflation because it wasn’t spent.  When people later take that money and spend it, it may cause inflation, but it won’t affect aggregate demand or supply until people spend the money.  Another example would be if the federal government gave money to banks in exchange for their government bonds, it wouldn’t automatically cause inflation.  It might lower interest rates, but unless those lower rates translate into more bank loans that are then spent into the economy, it isn’t going to cause inflation.

A lot of people thought that the Fed’s so-called  “Quantitative Easing” was going to cause massive inflation because more money was being pumped into banks.  It could have, but only if that money had translated into banks making more loans.  Since it didn’t(or at least no significant) increase loans, it didn’t do much to help the economy or increase inflation.  As this example demonstrates it’s important to distinguish between what actually causes inflation, and things that have been observed to indirectly cause it.  Because otherwise, we’ll all run around like Chicken Littles worrying about hyperinflation while the economy continues to tank.

The Useless Quantity Theory of Money

“If the government creates money all it’ll do is cause inflation and we’ll all suffer.” This is one of the deadliest lies we’ve been told for the last 40 years. For centuries, philosophers and economists thought that any increase in money would always increase prices. John Maynard Keynes pretty much set the record straight on that about 80 some years ago. But the idea has been resurrected in the last few decades and is now mainstream again. It’s this rationale that conservatives use to justify destroying social programs, budget cuts, and the basis for the current debt “ceiling” discussions in Washington. What makes the idea so insidious is that it makes sense on the surface. With most things, the more of something there is, the less it’s worth. But unlike most things, money has no intrinsic value. That makes it fundamentally different. Below I will show you the modern re-emergence of this theory and why it is bullshit.

Money has no value until it is spent. What that means is that only at the time of purchase does it have an effect on inflation. For instance whether a single dollar bill is spent 4 times, or 4 dollar bills are spent once, the effect is the same. To give an example of what I mean, let’s look at two scenarios:

One day, a cold man buys a coat from a coat shop for a dollar. Now let’s say the owner immediately gives that dollar to one of his employees as their salary for the day. The employee then turns around and buys a coat as well. The shop owner then takes that dollar and buys lunch at a cafe. The owner of the cafe then takes that dollar to the shop and buys a coat. Finally, the shop owner takes the dollar to the owner of a billboard and buys advertising. The billboard owner then takes that dollar and buys a coat with it. On the way home the shop owner buys a book with his dollar from the bookstore.

In the second scenario. Let’s change the order. The cold man, the cafe owner, the employee, and the billboard owner all come in to the coat shop in the morning and buy a coat for a dollar. At the end of the day, the shop owner takes those 4$ and pays his employee’s salary of 1$, buys dinner at the cafe, buys his billboard ad, and gets his book. That’s 8$ worth of activity from 4 single dollar bills.

In both scenarios, the end result is the same. 4 people have coats, the shop owner has payed his one employee, gotten a meal, has advertising, and bought a book. That’s 8$ worth of activity from a single dollar bill in the first scenario, and 8$ worth of activity from 4 single dollar bills in the second scenario. How is that possible? Doesn’t more money always mean higher prices? In short, No. The rate that money is spent also has an impact on prices. As far as prices and demand is concerned, a single dollar being spent 10 times has the same effect as 10$ being spent once.

This is something that economists have know for a long time. They even have a fancy, glazed-eye inducing formula to represent it. Money Price Formula They eventually boil the formula down to this. MV=PQ. In their own convoluted way, what economists are trying to say is that, All existing Money(M) multiplied by the average number of times it is spent(V) is equal(=) to the amount of goods in the economy(Q) * the average price of those goods(P).

For example, if in a small town there are only 10 physical dollars(M) and each dollar is spent 3 times(V) then that means there was 30$ worth of activity. So if there were only 3 things bought(Q) in that village(say a toaster, a coat, and a lighter), then their average price would have to be 10$(P). If there were 6 things bought, then the average price would have to be 5$. M times V must always equal P times Q. M * V = P * Q. This equation is non-controversial among all economists. It is logical and self-evident.

This finally brings me to the lie we’ve been told for decades. Some guy, decades ago, took that equation MV = PQ and said something to the effect, “well, if you ‘assume’ that the velocity of money is constant and that the economy cannot(or will not) increase the amount of goods, then any increase in the money supply will only serve to increase prices”. Algebraically, it makes perfect sense. If you assume that ‘V’ and ‘Q’ are constant, then making M bigger would HAVE to make P larger. Thus was born the Quantity Theory of Money. You probably see the problem with this already. ‘V’ and ‘Q’ are most certainly not constant! (Funnily enough, that same guy still managed towin a Nobel prize in economics.)

‘V’ or the velocity of money is not constant. That’s why during the start of a recession the federal government can run huge budget deficits and still see ‘P’ or prices go down. When people feel insecure about the economy, households save money in case of a layoff, and businesses don’t risk new investments. The rate money is spent goes down and in the case of 2008, completely eclipsed the increase in the money supply created by budget deficits.

The other assumption that ‘Q’ is constant is also bullshit. An increase in money or spending rate can make the number of goods in the economy(Q) go up instead of prices. Think of a car factory being inundated with requests for more parts. Instead of increasing prices they could add a third shift. As long as there are enough unemployed workers to hire for the third shift, the increase of MV will affect quantity(Q) and not prices(P). Q would increase instead of P as long as the ability to increase supply exists. If there aren’t enough workers (or some other constraint), then the factory would have to raise prices. This situation would exist when there is almost no one who is unemployed to be hired for the third shift. You might be asking “why wouldn’t the factory just increase prices and reap all those profits?” The answer is that if the factory just increased prices they would be susceptible to some other factory adding a third shift and keeping their prices low – or as economists like to put it, “firms increase quantity before prices to maintain their marketshare”.

Now you should be able to see the absurdity about worrying about rising prices when unemployment is so high. High unemployment means that ‘Q’ isn’t at it’s highest. Therefore increasing ‘M’ via federal budget deficits will have very negligible effects on ‘P’. Instead new jobs will be created and we can enjoy the increased goods without increased prices. Only when the economy is maxed out will budget deficits start increasing prices. It is at that point that we can start worrying about budget deficits and debt “ceilings”. Worrying about them before that happens is stupid.

I’ve tried to show in the most logical way I am capable, of why we shouldn’t fear increasing the amount of money at times like this. Now that you’ve seen the basis for the “Quantity Theory of Money” and the assumptions that it relies on, I hope you can see why it’s bullshit. While it may be “technically” true if it’s assumptions are true, the assumptions are rarely, if ever true.

Wait… Can we “afford” to kill Bin Laden?

We got the bastard. Osama bin Laden is dead. But, imagine if we applied the same litmus test to military expenditures as conservatives want to apply to social security and Education….

Picture Obama and his national security team debating if the united states has enough money to pay for the operation to kill Osama Bin Laden? Before executing the plan did they ask themselves questions like, “Will this crowd out investment?” “What will be the effect on the budget?” “Who will pay for it?” “Sure it’ll put soldiers to work, but those are government jobs, not REAL jobs.” “Can we afford this?” Of course they didn’t ask themselves those questions. They asked themselves, “Is this worth doing”? They decided “yes”. Then they asked “can we do it?” They looked and found that they had soldiers with guns and helicopters with fuel and said “Yes we can”. Then they gave the order.

They did what any government should do before venturing on a public good project. They asked “Should we do it?” Then they asked “Can we do it?” And the “can we do it?” has nothing to do with money or deficits. The only thing that should be considered is if the country has the resources to accomplish it. I get so sick of politically motivated calls for “austerity” and cries of “going broken” when everyday we make decisions the correct way: Are the resources there?

Our leaders are so used to thinking in terms of money, they forget what it represents. Resources. Since the government can create and spend however much money it needs, it’s never constrained by revenue or “borrowing”. The only thing it’s constrained by is available resources. If it exceeds resources, it shows up as inflation. This simple concept somehow got lost in Washington D.C.

Let’s apply this resource attitude to areas other than military. Should we have small class sizes? “Yes”. Do we have enough teachers to hire so that we can have small class sizes? “Yes” – as evidenced by the huge numbers of unemployed teachers. This is something we can do. It has nothing to do with “do we have enough money?” We can afford to hire these teachers until there are no more competent teachers to hire. When that happens, THEN we’ll have a resource constraint and inflation will occur.

Should we fix crumbling bridges? “Yes”. Do we have the resources? Do we have enough concrete and construction workers? “Yes” We have so many out-of-work people in the construction industry that can do it. We also have huge concrete companies that are or are going out-of-business. In other words, we have the resources.

Let’s do a counter-example. Should we give everyone a big screen 3D tv? “probably not”. Do we have the resources? They aren’t 300 million 3D T.V. sets. That means that even if the federal budget was in surplus, we couldn’t “AFFORD” to give one to everybody. It will cause inflation as more money chases after an inadequate amount of goods.

I’m not saying we shouldn’t spend on the military. We should use our military when it’s needed. That’s what it’s therefore. I am saying is that as long as our economy continues to be recessed. Idle people(unemployed) and idle resources(Capital) are sitting around begging to be used. But we don’t, because we’re afraid of fictional budget restraints(budget deficits). We have an army of unemployed waiting to be used. Why not use them for the public good? There are several needs in this country. Let’s use our other “army” to make all our lives better. Go America!

We Save When the Government Spends

As you know, for you to save money, someone else must go into debt.  As i explained last time, if 300 million people save one dollar, than one person must go into debt 300 million dollars.  One person who could do this is the federal government.  So if the entire private sector wants to save money, the federal government can be the entity that goes into debt.  In fact, the total savings of the private sector cannot go up unless the federal government goes into debt.

By total savings, I mean that if you add up how many dollars everyone has and then subtract the total amount everyone owes.   Since all money is created as a debt, this will net to 0 dollars.  However, if you pull out just one entity, say the federal government’s treasury, then you can say that one entities debt must equal the others savings because eventually it all must equal zero.  That’s why federal debt equals private saving.  In fact, I understand that most economics students learn this their first year of study.  Macroeconomics 101 teaches that government deficits = private savings.  This doesn’t appear to be a secret.

A couple caveats about this.  I’ve used the term “private sector” pretty broadly here.  I’ve taken it to mean everybody except the federal government.  Most people further divide up the private sector into foreign entities and then domestic private sector.  It still doesn’t change the fact that for these groups to save money, then the federal government must run a deficit.  Again, this is something economists already know.  They learn it as a math equation:  federal income + foreign income + private domestic income = 0.

Another caveat is that this only works for total dollars in the economy.  Some people try to dispute this concept be getting other assets mixed up with money.  An example might be that someone might be in debt, but they have a house that is worth the amount of their debt.  That is a good thing because it increases their networth, but it does not increase the amount of actual money that they have.  Somebody else, like the federal government, will have to go into debt for that person’s amount of money to go up.

So what is the point of all this?  The point is that if we want the private sector to save money, we must be prepared to let the federal government run budget deficits.  It is the only way that the total savings of everyone in the country to go up.  It also means that for anyone calling on the government to balance it’s budget, they are also calling for everyone else to start spending every dollar that they make.

Think of the consequences of this:  For the federal government to have a balanced budget, and for everyone to save money for their own retirement, everyone who is young must go deeply into debt.  While a system such as this is theoretically possible in a free market, it doesn’t seem like it would be very stable.  Another consequence is that for the federal government to run a budget surplus, the private sector has to spend more money than it makes.  Think about that.  If you thought budget deficits are unsustainable, budget surpluses are even more unsustainable because the private sector has to sink into debt for them to happen.

Therefore, anyone who advocates for balancing the federal budget is also arguing for the private sector to stop saving money.  Anyone who thinks the private sector should save money, must also be for the federal government to run budget deficits if they are to remain consistent.

Anyone who advocates that the private sector needs to save money and that the federal government to balance it’s budget is arguing for two mutually exclusive goals.  And yet, this is what politicians and think tanks on both sides advocate for.  While they all have different ideas how to achieve both, I don’t think many of them realize that they are mutually exclusive goals.  Back in 1999, they were patting each other on the back for balancing the budget at the same time op eds were being written that excoriated Americans for having a negative savings rate.  Now it’s the opposite.  We’re thrilled that the private savings rate is so high, at the same time politicians are trying to figure out ways to lower the federal budget deficit.  If politicians and media know that these two goals are opposed, they sure don’t act like it.

Reasons Budget Deficits and Inflation Don’t Always Align

In a recent post, I pointed out that government spending is limited by inflation, not revenue.  You might ask, “so what?  don’t federal budget deficits and inflation rise together?”  Well, not necessarily.  There are times when other conditions can affect inflation other than the federal budget.

Currency Destruction: If physical currency is destroyed or lost, that means it can no longer be used.  That results in less money in circulation.  Since there is less of it, it means the value of it rises.  If money is more valuable, then prices drop which means deflation.  Therefore, if someone just burned a whole pile of cash it would cause deflation.  Since only 6 to 7 percent of our money is physical  currency, I doubt this would ever happen in a large enough amount to have a measurable effect.  However, some of the following items will.

Personal Savings: People hoarding cash has the same deflating effect as destroying cash.  The only difference is that eventually the cash will eventually be brought back into circulation.  However, until it is brought back into circulation the effect is deflation.  Whether or not the cash is hoarded by putting it in a cookie jar at home, or by putting it in the bank, it can cause deflation.

Confident consumers can have an effect on inflation.  If a lot of loans are taken out it creates a lot of bank money.  This can have an inflating effect completely independent of any federal budget deficits.

A financial bubble or a bubble in any other sector of the economy becoming overly inflated can have an effect on the over all inflation rate.  While the bubble is forming a lot of extra bank money is pumped into the economy, inflating the supply of money.  Then, when the bubble bursts a lot of people default on their loans and that bank money disappears which causes deflation.  Both of these things can happen independently of any budget deficit or surplus.

Notice that all of these are things are results of decisions by consumers and decisions and cannot be directly controlled by federal spending decisions.  In other words, to keep inflation low and steady requires government policies to react to the private market.  Right now that mostly happens with the fed controlling the interest rates, but that doesn’t mean there aren’t other inflation regulating options out there.

The Federal Budget is Not Like Your Budget

Once upon a time, the budget of the U.S. government was just like your budget or any other household budget.  This was because at one time the government was on a gold standard.  Each dollar could be exchanged at anytime for either a small bit of gold, silver, or some combination of both.  The amount of goldsilver that you could get with a dollar would change every so often until it was changed for the last time when the United States entered the Bretton Woods system which set the value of the American dollar at 35$ per gold ounce.  Then, 27 years later, in 1971 on the Ides of August, Richard Milhouse Nixon sunk the third proverbial knife into the Gold Standard by announcing the end of gold convertibility of the U.S. dollar(West Germany and Switzerland were first and second to exit the Bretton Woods system).  The U.S. budget was no longer like a household budget.

So what do I mean when I say household budget?  A typical household or business must either earn or borrow money before it can spend it.  Everyone knows this:  You can’t spend 5$ until somebody else gives you 5$.  In other words your spending is “revenue constrained”.  When the U.S. had to convert dollars to gold, it was revenue constrained because it had a limited amount of gold.  Since 1971 the federal government no longer has to convert dollars to gold.  Combine that fact with the fact that the federal government, and only the federal government, can create dollars and you’ll realize that the federal government is no longer revenue constrained.

This last point bears repeating.  The U.S. government doesn’t have to tax or borrow money to spend it.  Most of us learn in our civic class that the government taxes it’s citizen and then spends it on roads and tanks and other items.  If the government needs more tanks or roads, it must raise taxes.  However, this is no longer the case for the federal government.  To buy the extra tanks or rail, the government can create money *poof* out of thin air to buy whatever it wants.  It could just create new money all day every day until the end of time and it would never run out or have to borrow or collect taxes.

From what I’ve seen, the first reaction most people have to this statement of fact is, “Inflation!  Inflation! Inflation! What about Inflation?” which just proves the point.  I think most people realize that the government isn’t revenue constrained because nobody ever seems to say, “That’s not true, the government can’t spend whatever it wants!  It’ll run out of dollars.”, they just object to the obvious consequence of a government spending way more than it makes in taxes: inflation.  So let’s put these these two statement of facts together.  If government spending isn’t revenue constrained, but can cause inflation when it spends a lot, then government spending is constrained by inflation, not revenue.

Why is this significant?  Because if federal spending is constrained by inflation and not tax receipts, then it completely changes when the government can “afford” something.  If inflation is low or negative, then the federal government can spend more money or cut taxes. If inflation is high, then the federal government can’t afford any more tax cuts or spending.  In fact, that means the government should spend less andor raise taxes.  These last two statements hold true no matter how high or low the current budget deficitsurplus is.  This means that if inflation is negative, the government can “afford” to cut taxes and increase spending even if it’s already in debt.  It also means that if inflation is high, the government needs to increase taxes and decrease spending even if it has a budget surplus.

As you can see, this is not like your budget at all.  Where your budget requires you to make every dollar you spend, the federal government’s budget does not require this.  The fact that government spending is constrained by inflation and not revenue is one of the central facts that Modern Money Theory is built on.

All I’ve said in this post is that government spending is constrained by inflation, not revenue.  What I did not say is that the government can  or should spend all willy-nilly without consequence.  There is a consequence and it is inflation.  What I am saying is that when congress decides if it can “afford” to do something, it shouldn’t make that determination based on what the current budget deficitsurplus is, it should make that decision based on how high inflation is.  Unfortunately, the people running our country either don’t realize this or act like they don’t realize this.