Why the Fiscal Cliff Should Not be a Problem but is One
by Robert P. Coutinho
It’s time for another lesson in my ongoing saga of teaching people about how money (in the Federal Government sense) actually works. The reason for this lesson: the Fiscal Cliff.
The government of the United States of America [hearafter referred to as USG] issues its debt in dollar denominations. That means, quite literally, that they could just print the dollars to settle all the outstanding bonds currently held by their investors (in other words, the people who are earning interest on T-bills). This would be a disastrous policy if it were implemented all at once as it would lead to massive inflation and might even lead to hyperinflation (see Zimbabwe, where they have loads of billionaires, as an example). It also means that the USG government does not need to ever pay off its debt.
Wait! What?
In order for the USG to pay off all of its loans, it would need to obtain that money from the private sector (note that the private sector might include foreign entities including the European Central Bank, Bank of China, etc.) If the USG did actually collect enough revenue (say over the next fifty or so years) to pay off the debt, we would likely face a depression during the entire time that we conducted such a policy.
Why?
Because the only way for the USG to pay off debt is by taking more money out of the private sector than it puts into it. That means that overall savings in the private sector would have to be reduced—catastrophically–in order to pay off the debt.
This does not mean that we can sustain deficits (the amount extra that we borrow each year) at the levels we are currently running. Typically a deficit of about 0.7% less than the Federal Reserve lending rate is a sustainable amount—in perpetuity. We have not seen such a thing for over a decade.
Before the Clinton/Republican Party fiscal surplus times, we had not seen a deficit that was sustainable for several decades.
The problem with all of this “debt” talk is that there is very little reason for the USG to borrow the money in the first place. You see, they make the money—literally. If the USG did not spend money into existence then the only money that would be out there (in dollars) would be that which had been borrowed in the private sector from banks. The reason is because banks do not lend the money that has been deposited in their institutions. They create the borrowed money out of nothing.
Thus, the only problem a bank has in issuing a loan is making sure that it can show a cash capacity to honor the likely day to day drawing on its funds. Banks typically go to the money markets to buy (and sell) short term paper to solve any discrepancies at the end of the day. The Federal Reserve acts as the seller of last resort.
Since the Federal Reserve has a lending rate of 0.25% (per year!) at the moment, there is little incentive for any financial institution that has access to the Fed to borrow money in the money market. The money market was the one that crashed in the 2008 debacle (primarily because the loans that the “assets” were based on in many of the financial institutions were fraudulent, thus no one trusted that anyone else could pay up). You don’t have access to that money market (or the Fed).
You have to find a financial institution that is willing to sell you a loan. At the moment, the interest rate on your loan is almost all profit for the bank. Since they can borrow for virtually nothing, they can sell loans at enormous mark-up. (I kind of wish that I could own one of these banks, then charge customers thirty-two to eighty times the amount that I am getting charged. That would be a really sweet deal!)
As I said, the loans that they sell create the money lent, however that only lasts until the loans are paid back. In a net sense, banks do not create extra money in the economy because the loan that is outstanding counterbalances the money lent. Banks use a ledger with assets and liabilities. The money created by a loan will end up deposited in a bank somewhere (unless the seller happens to just burn the money or something—usually that is not even possible as the transactions take place in cyberspace).
Since a bank somewhere will have a deposit that is counterbalanced by the outstanding loan, no net increase of money has been created. So…if the USG were to pay off its entire debt via revenue ($16.3 trillion as of 30 Nov, 2012 around 4:00 am EST), the economy would see a net loss of $16.3 trillion dollars. That would be kind of a big hit. It is also completely unnecessary.
Why? Because the only good reason for the USG to raise taxes or lower spending is to prevent too much inflation. As I mentioned in numerous articles already, when the USG spends money, it spends it into existence. When it collects taxes, it taxes the money out of existence. Thus, the USG need only worry about reducing the quantity of money it is creating in order to prevent inflation from being too high.
Remember when I mentioned that banks create the money they lend to us? Well, that makes a difference in peoples’ lives more than most of us realize. Way back when (during Reagan’s tenure), the middle class began to need two earners per family in order to keep up with their desired standard of living. When two incomes became too little to keep up the standard of living, they borrowed against the perceived equity in their homes. When that equity dried up (read: the housing market crashed), households saw a drop in their collective assets in the trillions of dollars.
One site that I read suggested that the loss was about $4.5 T. Couple that with the perceived loss of about $7 T for the dotcom bust and you can see that there was some loss of equity over that ten year period (1998-2008) that came close to the entire Gross Domestic Product (GDP) (a measure of all the goods and services produced in the US for a year) of the United States. When an economy gets the bad news about its assets such as those two hits, the economy usually sees what financial types like to call “A Correction.”
In other words, families immediately stopped borrowing on the equity in their homes (because, you see, they didn’t really have that equity in the first place) and began paying off the loans that they had taken out. Because so many of us stopped spending borrowed money, businesses saw a drop in sales. They reduced their workforce, which led to panic among workers (for a good reason) and caused them to spend even less.
Now the good news: the USG began spending money back into the system. Well, “back into,” may not be the right term. They spent even more money into the system (without taxing it out) in an effort to make up for some of the lost demand from the private sector. That net spending is what is called a deficit. They issued bonds covering the amount that was spent over the amount that was taxed, however a lot of those bonds were purchased by the Federal Reserve.
Since all profits realized by the Federal Reserve go into the US Treasury, we basically borrowed the money from ourselves and will pay interest to ourselves. In addition, there were lots of foreign entities who were virtually begging us to “borrow” their money. This lowered the interest rate on the bonds. There were times when that interest rate was actually negative (meaning that people were paying the USG to hold their money for them).
Back to the bad news: most of the officials in the government do not know how money works. Thus, the Fiscal Cliff (mandated tax increases and spending cuts) would trash the economy since the USG would no longer be providing as much extra demand for goods and services, compared to the amount that they took back out of the system. Whenever anyone from the USG talks about spending cuts or tax increases, the net result on the economy (minus some nearly negligible tweaking) is the same.
Now, it is true that the wealthy do not spend nearly as much of their income as the poor, so taxing them might seem like a good move to prevent inflation in the future. However, taxing them will still reduce the amount of net money that the USG adds into the economy. Very likely the amount that the wealthy pay in taxes will be less of a hit than the spending cuts on programs for the poor, but both will be drags on the economy.
Why do I know this stuff while people with advanced degrees in economics seem oblivious to this? I am disabled (as of about September of 1997), but I am a voracious scholar. I have had little else to do other than follow such things as politics (and economics), so I began learning about all this stuff from some very smart people.
Why do I think these people know what they are talking about? Because they are the ones who correctly predicted the dotcom bust and the housing bubble and bust. In addition, they predicted the problems that the Eurozone is currently facing. As a trained scientist (chemistry), I usually go with models that show themselves to be robust in their predictions of outcomes. Many economists in 2007 insisted that the sub-prime mortgage market would be a hit of around $300 billion to the financial sector. They were absolutely astonished that the real hit almost collapsed the entire world economy.
The people I learned from had predicted that the sub-prime bust would extend into the regular mortgage market and that the housing industry would be on life-support (and that the housing industry was the driver of the rise in GDP that we had seen since the dotcom bust).
Now back to the Fiscal Cliff: we can not continue to borrow 4-7% of GDP each year (nor can we afford to simply create it, which would actually be a far better alternative than paying interest on it to bankers and wealthy investors).
The problem is that the economic rebound that we have seen has been anemic at best. In addition, almost all of the rebound has gone to corporations and very wealthy individuals. If you were paying attention during the past year, you may have heard that the average income for middle class and poor families went down during President Obama’s first term.
Since the economy is still barely growing, any hit could easily send it right back into recession (that is, GDP would fall, instead of rising about 1-2% like it has during the past three years).
Meanwhile, corporate America has seen record profits (due in no small part to them reducing their work force) and is sitting on some $1.5-$2 trillion dollars of cash. Thus, they do not (at least in net aggregate) need low interest rates in order to grow. In addition, they do not need the super-wealthy to have low tax rates on capital gains (they already have the money to invest).
What they need are buyers of their products. In order for them to get buyers for their products, the American middle class (and poor to some extent) needs to get a pay raise. However, businesses are not giving out pay raises because of the high unemployment, which will remain high so long as the middle class does not increase its spending (70% of the GDP is due to consumer spending).
To be perfectly honest, if I were W. Mitt Romney I would be breathing a sigh of relief that I lost the election. Or, more likely, I would be hiring people like Dr. William Black and Dr. Warren Mosler as my economic team. Maybe President Obama will find men such as these. I hope so—for all our sakes’.
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Robert Coutinho is a disabled pharmaceutical chemist living in Massachusetts. He has been learning about life, the universe, and everything since he was born in 1963. He has had little else to do since his disability began in 1997. He has written a fictional novel, Their Last Best Hope, which is currently available at Tate Publishing, Amazon and book stores.