Fiscal Cliffs, Debt Limits, and Unsustainable Deficits: Can the US Really Run Out of Dollars? L. RANDALL WRAY, LEVY INSTITUTE & UMKC

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 ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” Mark Twain First let’s 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?

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 Gov’t 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

PRIVATE SECTOR BALANCE + GOVERNMENT BALANCE = CURRENT ACCOUNT BALANCE Accounting Identity of Financial Balances INTERNAL FINANCIAL BALANCE EXTERNAL FINANCIAL BALANCE THE CONCEPTUAL FRAMEWORK

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 doesn’t face insolvency, and b)why deficits don’t 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 bank’s reserves; bank credits account of recipient Taxes  debits Government debits bank’s reserves; bank debits account of taxpayer Deficits  net credits Government net credits bank’s 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 Fed’s 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 Doesn’t matter whether bonds must be sold first—so long as CB accommodates reserve demand Doesn’t matter whether CB prohibited from buying new issues—roundabout through banks Doesn’t matter whether Treasury must have “money” in its acct at CB to spend—CB 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 state’s 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 ) Alaska15.7Montana12.2 Connecticut12.1New Hampshire13.0 Hawaii12.2New York10.5 Maine11.0Rhode Island16.9 Massachusetts16.5Vermont12.6

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