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Foreword
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Money is created by government spending (or by bank loans, which create deposits). Taxes serve to make us want that money—we need it in order to pay the taxes. And they help regulate total spending, so that we don’t have more total spending than we have goods available at current prices—something that would force up prices and cause inflation. But taxes aren’t needed in advance of spending—and could hardly be, since before the government spends there is no money to tax.
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Public deficits increase financial private savings—as a matter of accounting, dollar for dollar. Imports are a benefit, exports a cost. We do not borrow from China to finance our consumption: the borrowing that finances an import from China is done by a U.S. consumer at a U.S. bank.
Prologue
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The term “innocent fraud” was introduced by Professor John Kenneth Galbraith in his last book, The Economics of Innocent Fraud,
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The presumption of innocence, yet another example of Galbraith’s elegant and biting wit, implies those perpetuating the fraud are not only wrong, but also not clever enough to understand what they are actually doing. And
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Galbraith was largely a Keynesian who believed that only fiscal policy can restore “spending power.” Fiscal policy is what economists call tax cuts and spending increases, and spending in general is what they call aggregate demand. Galbraith’s academic antagonist, Milton Friedman, led another school of thought known as the “monetarists.” The monetarists believe the federal government should always keep the budget in balance and use what they called “monetary policy” to regulate the economy. Initially that meant keeping the “money supply” growing slowly and steadily to control inflation, and letting the economy do what it may. However they never could come up with a measure of money supply that did the trick nor could the Federal Reserve ever find a way to actually control the measures of money they experimented with.
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Paul Volcker was the last Fed Chairman to attempt to directly control the money supply. After a prolonged period of actions that merely demonstrated what most central bankers had known for a very long time— that there was no such thing as controlling the money supply—Volcker abandoned the effort. Monetary policy was quickly redefined as a policy of using interest rates as the instrument of monetary policy rather than any measures of the quantity of money. And “inflation expectations” moved to the top of the list as the cause of inflation, as the money supply no longer played an active role. Interestingly, “money” doesn’t appear anywhere in the latest monetarist mathematical models that advocate the use of interest rates to regulate the economy.
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Keynesian views lost out to the monetarists when the “Great Inflation” of the 1970s sent shock waves through the American psyche. Public policy turned to the Federal Reserve and its manipulation of interest rates as the most effective way to deal with what was coined “stagflation”—the combination of a stagnant economy and high inflation.
Introduction
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It is my contention that the seven deadly innocent frauds of economic policy are all that is standing between today’s economic mess and the full restoration of American prosperity.
Part I: The Seven Deadly Innocent Frauds
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Deadly Innocent Fraud #1: The federal government must raise funds through taxation or borrowing in order to spend. In other words, government spending is limited by its ability to tax or borrow. Fact: Federal government spending is in no case operationally constrained by revenues, meaning that there is no “solvency risk.” In other words, the federal government can always make any and all payments in its own currency, no matter how large the deficit is, or how few taxes it collects.
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How are you going to pay for it???!!! This is the killer question, the one no one gets right, and getting the answer to this question right is the core of the public purpose behind writing this book. In the next few moments of reading, it will all be revealed to you with no theory and no philosophy- just a few hard cold facts. I answer this question by first looking at exactly how government taxes, followed by how government spends.
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And what happens if you were to go to your local IRS office to pay your taxes with actual cash? First, you would hand over your pile of currency to the person on duty as payment. Next, he’d count it, give you a receipt and, hopefully, a thank you for helping to pay for social security, interest on the national debt, and the Iraq war. Then, after you, the tax payer, left the room, he’d take that hard-earned cash you just forked over and then send them out to be shredded (any older cash used to make payments to Federal Reserve Member banks is sent to the shredder). Yes, it gets thrown it away. Destroyed! Why? There’s no further use for it. Just like a ticket to the Super Bowl. After you enter the stadium and hand the attendant a ticket that was worth maybe $1000, he tears it up and discards it. In fact, you can actually buy shredded money in Washington, D.C.
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if the government doesn’t actually get anything when it taxes, how and what does it spend?
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The federal government doesn’t ever “have” or “not have” any dollars.
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This is not to say that excess government spending won’t possibly cause prices to go up (which is inflation).
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Do the parents have to somehow get coupons from their children before they can pay their coupons to their children to do chores? Of course not! In fact, the parents must first spend their coupons by paying their children to do household chores, to be able to collect the payment of 10 coupons a week from their children. How else can the children get the coupons they owe to their parents? Likewise, in the real economy, the federal government, just like this household with its own coupons, doesn’t have to get the dollars it spends from taxing or borrowing, or anywhere else, to be able to spend them.
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let’s build a national currency from scratch. Imagine a new country with a newly announced currency. No one has any. Then the government proclaims, for example, that there will be a property tax. Well, how can it be paid? It can’t, until after the government starts spending. Only after the government spends its new currency does the population have the funds to pay the tax.
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We need the federal government’s spending to get the funds we need to pay our taxes.
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So the next time you hear: “Where will the money for Social Security come from?” go ahead and tell them, “It’s just data entry. It comes from the same place as your score at the bowling alley.”
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Governments, using their own currency, can spend what they want, when they want, just like the football stadium can put points on the board at will. The consequences of overspending might be inflation or a falling currency, but never bounced checks. The fact is: government deficits can never cause a government to miss any size of payment. There is no solvency issue.
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Why the Federal Government Taxes So why then does the federal government tax us, if it doesn’t actually get anything to spend or need to get anything to spend?
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There is a very good reason it taxes us. Taxes create an ongoing need in the economy to get dollars, and therefore an ongoing need for people to sell their goods and services and labor to get dollars. With tax liabilities in place, the government can buy things with its otherwise-worthless dollars, because someone needs the dollars to pay taxes.
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now you are motivated to sell things —goods, services, your own labor—to get the dollars you need.
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let’s go back to the example of a new country with a new currency, which I’ll call “the crown,” where the government levies a property tax. Let’s assume the government levies this tax for the further purpose of raising an army, and offers jobs to soldiers who are paid in “crowns.” Suddenly, a lot of people who own property now need to get crowns, and many of them won’t want to get crowns directly from the government by serving as soldiers. So they start offering their goods and services for sale in exchange for the new crowns they need and want, hoping to get these crowns without having to join the army. Other people now see many things for sale they would like to have—chickens, corn, clothing and all kinds of services like haircuts, medical services and many other services. The sellers of these goods and services want to receive crowns to avoid having to join the army to get the money they need to pay their taxes. The fact that all these things are being offered for sale in exchange for crowns makes some other people join the army to get the money needed to buy some of those goods and services.
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In fact, prices will adjust until as many soldiers as the government wants are enticed to join the army. Because until that happens, there won’t be enough crowns spent by the government to allow the taxpayers to pay all of their taxes, and those needing the crowns, who don’t want to go into the army, will cut the prices of their goods and services as much as they have to in order to get them sold, or else throw in the towel and join the army themselves.
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The following is not merely a theoretical concept. It’s exactly what happened in Africa in the 1800’s, when the British established colonies there to grow crops. The British offered jobs to the local population, but none of them were interested in earning British coins. So the British placed a “hut tax” on all of their dwellings, payable only in British coins. Suddenly, the area was “monetized,” as everyone now needed British coins, and the local population started offering things for sale, as well as their labor, to get the needed coins. The British could then hire them and pay them in British coins to work the fields and grow their crops.
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taxation is fundamentally coercive
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A learned economist today would say that “taxes function to reduce aggregate demand.” Their term, “aggregate demand,” is just a fancy term for “spending power.”
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The government taxes us and takes away our money for one reason—so we have that much less to spend which makes the currency that much more scarce and valuable.
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Taking away our money can also be thought of as leaving room for the government to spend without causing inflation. Think of the economy as one big department store full of all the goods and services we all produce and offer for sale every year. We all get paid enough in wages and profits to buy everything in that store, assuming we would spend all the money we earn and all the profits we make. (And if we borrow to spend, we can buy even more than there is in that store.) But when some of our money goes to pay taxes, we are left short of the spending power we need to buy all of what’s for sale in the store. This gives government the “room” to buy what it wants so that when it spends what it wants, the combined spending of government and the rest of us isn’t too much for what’s for sale in the store.
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However, when the government taxes too much—relative to its spending—total spending isn’t enough to make sure everything in the store gets sold. When businesses can’t sell all that they produce, people lose their jobs and have even less money to spend, so even less gets sold. Then more people lose their jobs, and the economy goes into a downward spiral we call a recession.
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Keep in mind that the public purpose behind government doing all this is to provide a public infrastructure. This includes the military, the legal system, the legislature and the executive branch of government, etc. So there is quite a bit that even the most conservative voters would have the government do.
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So I look at it this way: for the “right” amount of government spending, which we presume is necessary to run the nation the way we would like to see it run, how high should taxes be? The reason I look at it this way is because the “right amount of government spending” is an economic and political decision that, properly understood, has nothing to do with government finances. The real “costs” of running the government are the real goods and services it consumes—all the labor hours, fuel, electricity, steel, carbon fiber, hard drives, etc. that would otherwise be available for the private sector. So when the government takes those real resources for its own purposes, there are that many fewer real resources left for privatesector activity. For example, the real cost of the “right-size” army with enough soldiers for defense is that there are fewer workers left in the private sector to grow the food, build the cars, do the doctoring and nursing and administrative tasks, sell us stocks and real estate, paint our houses, mow our lawns, etc. etc. etc. Therefore, the way I see it, we first set the size of government at the “right” level of public infrastructure, based on real benefits and real costs, and not the “financial” considerations. The monetary system is then the tool we use to achieve our real economic and political objectives, and not the source of information as to what those objectives are. Then, after deciding what we need to spend to have the right-sized government, we adjust taxes so that we all have enough spending power to buy what’s still for sale in the “store” after the government is done with its shopping. In general, I’d expect taxes to be quite a bit lower than government spending, for reasons already explained and also expanded on later in this book. In fact, a budget deficit of perhaps 5% of our gross domestic product might turn out to be the norm, which in today’s economy is about $750 billion annually. However, that number by itself is of no particular economic consequence, and could be a lot higher or a lot lower, depending on the circumstances. What matters is that the purpose of taxes is to balance the economy and make sure it’s not too hot nor too cold. And federal government spending is set
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That means we should NOT grow the size of government to help the economy out of a slowdown. We should already be at the right size for government,
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So while increasing government spending during a slowdown will indeed make the numbers work, and will end the recession, for me that is far less desirable than accomplishing the same thing with the right tax cuts in sufficient-enough size to restore private-sector spending to the desired amounts.
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Even worse is increasing the size of government just because the government might find itself with a surplus. Again, government finances tell us nothing about how large the government should be. That decision is totally independent of government finances. The right amount of government spending has nothing to do with tax revenues or the ability to borrow, as both of those are only tools for implementing policy on behalf of public purpose, and not reasons for spending or not spending, and not sources of revenue needed for actual government spending.
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my vision is for a far more streamlined and efficient government, one that is intensely focused on the basics of fundamental public purpose. Fortunately, there are readily available and infinitely sensible ways to do this. We can put the right incentives in place which channel market forces with guidance to better promote the public purpose with far less regulation. This will result in a government and culture that will continue to be the envy of the world. It will be a government that expresses our American values of rewarding hard work and innovation, and promoting equal opportunity, equitable outcomes and enforceable laws and regulations we can respect with true pride.
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the government taxes us, and takes away our money, to prevent inflation, not to actually get our money in order to spend it. Restated one more time: Taxes function to regulate the economy, and not to get money for Congress to spend.
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as long as government continues to believe this first of the seven deadly innocent frauds, that they need to get money from taxing or borrowing in order to spend, they will continue to support policies that constrain output and employment and prevent us from achieving what are otherwise readily-available economic outcomes.
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Deadly Innocent Fraud #2: With government deficits, we are leaving our debt burden to our children. Fact: Collectively, in real terms, there is no such burden possible. Debt or no debt, our children get to consume whatever they can produce.
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Professional economists call this the “intergenerational” debt issue. It is thought that if the federal government deficit spends, it is somehow leaving the real burden of today’s expenditures to be paid for by future generations.
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Here’s a story that illustrates the point. Several years ago, I ran into former Senator and Governor of Connecticut, Lowell Weicker, and his wife Claudia on a boat dock in St. Croix. I asked Governor Weicker what was wrong with the country’s fiscal policy. He replied we have to stop running up these deficits and leaving the burden of paying for today’s spending to our children.
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So I then asked him the following questions to hopefully illustrate the hidden flaw in his logic: “When our children build 15 million cars per year 20 years from now, will they have to send them back in time to 2008 to pay off their debt?
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Of course, we all know we don’t send real goods and services back in time to pay off federal government deficits, and that our children won’t have to do that either.
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In other words, when the U.S. government does what’s called “borrowing money,” all it does is move funds from checking accounts at the Fed to savings accounts (Treasury securities) at the Fed. In fact, the entire $13 trillion national debt is nothing more than the economy’s total holdings of savings accounts at the Fed.
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And what happens when the Treasury securities come due, and that “debt” has to be paid back? Yes, you guessed it, the Fed merely shifts the dollar balances from the savings accounts (Treasury securities) at the Fed to the appropriate checking accounts at the Fed (reserve accounts).
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Federal Government Taxing and Spending Does Influence Distribution Distribution is about who gets all the goods and services that are produced. In fact, this is what politicians do every time they pass legislation. They re-direct real goods and services by decree, for better or worse. And the odds of doing it for better are substantially decreased when they don’t understand the Seven Deadly Innocent Frauds.
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each year’s output is “divided up” among the living. None of the real output gets “thrown away” because of outstanding debt, no matter how large. Nor does outstanding debt reduce output and employment, except of course when ill-informed policymakers decide to take anti-deficit measures that do reduce output and employment. Unfortunately, that is currently the case, and that is why this is a deadly innocent fraud.
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So How Do We Pay Off China? Those worried about paying off the national debt can’t possibly understand how it all works at the operational, nuts and bolts (debits and credits) level. Otherwise they would realize that question is entirely inapplicable.
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China has a reserve account at the Federal Reserve Bank. To quickly review, a reserve account is nothing more than a fancy name for a checking account. It’s the Federal Reserve Bank so they call it a reserve account instead of a checking account. To pay China, the Fed adds 1 billion U.S. dollars to China’s checking account at the Fed. It does this by changing the numbers in China’s checking account up by 1 billion U.S. dollars. The numbers don’t come from anywhere any more than the numbers on a scoreboard at a football come from anywhere. China then has some choices. It can do nothing and keep the $1 billion in its checking account at the Fed, or it can buy U.S. Treasury securities.
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let’s say China buys a one-year Treasury security. All that happens is that the Fed subtracts $1 billion from China’s checking account at the Fed, and adds $1 billion to China’s savings account at the Fed. And all that happens a year later when China’s one-year Treasury bill comes due is that the Fed removes this money from China’s savings account at the Fed (including interest) and adds it to China’s checking account at the Fed.
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Right now, China is holding some $2 trillion of U.S. Treasury securities. So what do we do when they mature and it’s time to pay China back? We remove those dollars from their savings account at the Fed and add them to their checking account at the Fed, and wait for them to say what, if anything, they might want to do next. This is what happens when all U.S. government debt comes due, which happens continuously. The Fed removes dollars from savings accounts and adds dollars to checking accounts on its books. When people buy Treasury securities, the Fed removes dollars from their checking accounts and adds them to their savings accounts. So what’s all the fuss? It’s all a tragic misunderstanding.
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Deadly Innocent Fraud #3: Federal Government budget deficits take away savings. Fact: Federal Government budget deficits ADD to savings.
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Any $U.S. government deficit exactly EQUALS the total net increase in the holdings ($U.S. financial assets) of the rest of us—businesses and households, residents and nonresidents—what is called the “non-government” sector. In other words, government deficits equal increased “monetary savings” for the rest of us, to the penny.
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Simply put, government deficits ADD to our savings (to the penny). This is an accounting fact, not theory or philosophy. There is no dispute. It is basic national income accounting.
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ask anyone at the CBO (Congressional Budget Office), as I have, and they will tell you they must “balance the checkbook” and make sure the government deficit equals our new savings, or they would have to stay late and find their accounting mistake.
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let’s demonstrate how deficits do ADD to savings, and not just shift savings: 1. Start with the government selling $100 billion in Treasury securities. (Note: this sale is voluntary, which means that the buyer buys the securities because he wants to. Presumably, he believes that he is better off buying them than not buying them. No one is ever forced to buy government securities. They get sold at auction to the highest bidder who is willing to accept the lowest yield.) 2. When the buyers of these securities pay for them, checking accounts at the Fed are reduced by $100 billion to make the payment. In other words, money in checking accounts at the Fed is exchanged for the new Treasury securities, which are savings accounts at the Fed. At this point, non-government savings is unchanged. The buyers now have their new Treasury securities as savings, rather than the money that was in their checking accounts before they bought the Treasury securities. 3. Now the Treasury spends $100 billion after the sale of the $100 billion of new Treasury securities, on the usual things government spends its money on. 4. This Treasury spending adds back $100 billion to someone’s checking accounts. 5. The non-government sector now has its $100 billion of checking accounts back AND it has the $100 billion of new Treasury securities. Bottom line: the deficit spending of $100 billion directly added $100 billion of savings in the form of new Treasury securities to non-government savings (non-government means everyone but the government).
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There can’t be a budget surplus with private savings increasing (including non-resident savings of $U.S. financial assets).
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the last six periods of surplus in our more than two hundred-year history had been followed by the only six depressions in our history.
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Professor Wynne Godley, retired head of Economics at Cambridge University and now over 80 years old, was widely renowned as the most successful forecaster of the British economy for multiple decades. And he did it all with his “sector analysis,” which had at its core the fact that the government deficit equals the savings of financial assets of the other sectors combined. However, even with the success of his forecasting, the iron-clad support from the pure accounting facts, and the weight of his office (all of which continues to this day), he has yet to convince the mainstream of the validity of his teachings.
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So what is the role of deficits in regard to policy? It’s very simple. Whenever spending falls short of sustaining our output and employment, when we don’t have enough spending power to buy what’s for sale in that big department store we call the economy, government can act to make sure that our own output is sold by either cutting taxes or increasing government spending. Taxes function to regulate our spending power and the economy in general. If the “right” level of taxation needed to support output and employment happens to be a lot less than government spending, that resulting budget deficit is nothing to be afraid of regarding solvency, sustainability, or doing bad by our children.
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The choices are political. The right-sized deficit is the one that gets us to where we want to be with regards to output and employment, as well as the size of government we want, no matter how large or how small a deficit that might be. What matters is real life—output and employment— not the size of the deficit, which is an accounting statistic. In the 1940’s, an economist named Abba Lerner called this, “Functional Finance,” and wrote a book by that name (which is still very relevant today).
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Deadly Innocent Fraud #4: Social Security is broken. Fact: Federal Government Checks Don’t Bounce.
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One of the major discussions in Washington is whether or not to privatize Social Security. As you might be guessing by now, that entire discussion makes no sense whatsoever, so let me begin with that and then move on. What is meant by the privatization of Social Security, and what effect does that have on the economy and you as an individual? The idea of privatization is that: 1. Social Security taxes and benefits are reduced.
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2. The amount of the tax reduction is used to buy specified shares of stock. 3. Because the government is going to collect that much less in taxes, the budget deficit will be that much higher, and so the government will have to sell that many more Treasury securities to “pay for it all” (as they say).
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Got it? In simpler words: - You have less taken out of your paycheck for Social Security each week. - You get to use the funds they no longer take from you to buy stocks. - You later will collect a bit less in Social Security payments when you retire. - You will own stocks which will hopefully become worth more than the Social Security payments that you gave up.
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The major flaw in this mainstream dialogue is what is called a “fallacy of composition.” The typical textbook example of a fallacy of composition is the football game where you can see better if you stand up, and then
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conclude that everyone would see better if everyone stood up.
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They all are looking at the micro level, which is individual Social Security participants, rather than looking at the macro level, the entire population.
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To understand what’s fundamentally wrong at the macro (big picture, top down) level, you first have to understand that participating in Social Security is functionally the same as buying a government bond. Let me explain. With the current Social Security program, you give the government your dollars now, and it gives you back dollars later. This is exactly what happens when you buy a government bond
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“So what has happened is that the employees stopped buying into Social Security, which we agree was functionally the same as buying a government bond, and instead they bought stocks. And other people sold their stocks and bought the newlyissued government bonds. So looking at it from the macro level, all that happened is that some stocks changed hands and some bonds changed hands. Total stocks outstanding and total bonds outstanding, if you count Social Security as a bond, remained about the same. And so this should have no influence on the economy or total savings, or anything else apart from generating transactions costs?”
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The proposal in no way changes the number of shares of stock or which stocks the American public would hold for investment. So at the macro level, it is not the case of allowing the nation to “invest better than the government can.”
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Let’s look at it this way: 50 years from now when there is one person left working and 300 million retired people (I exaggerate to make the point), that guy is going to be pretty busy since he’ll have to grow all the food, build and maintain all the buildings, do the laundry, take care of all medical needs, produce the TV shows, etc. etc. etc. What we need to do is make sure that those 300 million retired people have the funds to pay him??? I don’t think so! This problem obviously isn’t about money. What we need to do is make sure that the one guy working is smart enough and productive enough and has enough capital goods and software to be able to get it all done, or else those retirees are in serious trouble, no matter how much money they might have. So the real problem is, if the remaining workers aren’t sufficiently productive, there will be a general shortage of goods and services. More “money to spend” will only drive up prices and not somehow create more goods and services.
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the story gets even worse. Any mainstream economist will agree that there pretty much isn’t anything in the way of real goods we can produce today that will be useful 50 years from now. They go on to say that the only thing we can do for our descendants that far into the future is to do our best to make sure they have the knowledge and technology to help them meet their future demands. The irony is that in order to somehow “save” public funds for the future, what we do is cut back on expenditures today, which does nothing but set our economy back and cause the growth of output and employment to decline. And worse yet, the great disappointment is that the first thing our misguided leaders cut back on is education—the one thing that the mainstream agrees should be done that actually helps our children 50 years down the road. Should our policy makers ever actually get a handle on how the monetary system functions, they would realize that the issue is social equity, and possibly inflation, but never government solvency. They would realize that if they want seniors to have more income at any time, it’s a simple matter of raising benefits, and that the real question is, what level of real resource consumption do we want to provide for our seniors? How much food do we want to allocate to them? How much housing? Clothing? Electricity? Gasoline? Medical services? These are the real issues, and yes, giving seniors more of those goods and services means less for us. The amount of goods and services we allocate to seniors is the real cost to us, not the actual payments, which are nothing more than numbers in bank accounts. And if our leaders were concerned about the future, they would support the types of education they thought would be most valuable for that purpose. They don’t understand the monetary system, though, and won’t see it the “right way around” until they do understand it. Meanwhile, the deadly innocent fraud of Social Security takes its toll on both our present and our future well-being.
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Deadly Innocent Fraud #5: The trade deficit is an unsustainable imbalance that takes away jobs and output. Facts: Imports are real benefits and exports are real costs. Trade deficits directly improve our standard of living. Jobs are lost because taxes are too high for a given level of government spending, not because of imports.
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going to work to produce real goods and services to export for someone else to consume does you no economic good at all, unless you get to import and consume the real goods and services others produce in return. Put more succinctly: The real wealth of a nation is all it produces and keeps for itself, plus all it imports, minus what it must export.
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A trade deficit, in fact, increases our real standard of living. How can it be any other way? So, the higher the trade deficit the better.
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If, for example, General MacArthur had proclaimed after World War II that since Japan had lost the war, they would be required to send the U.S. 2 million cars a year and get nothing in return, the result would have been a major international uproar about U.S. exploitation of conquered enemies. We would have been accused of fostering a repeat of the aftermath of World War I, wherein the allies demanded reparations from Germany which were presumably so high and exploitive that they caused World War II. Well, MacArthur did not order that, yet for over 60 years, Japan has, in fact, been sending us about 2
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million cars per year, and we have been sending them little or nothing. And, surprisingly, they think that this means they are winning the “trade war,” and we think it means that we are losing it. We have the cars, and they have the bank statement from the Fed showing which account their dollars are in. Same with China—they think that they are winning because they keep our stores full of their products and get nothing in return, apart from that bank statement from the Fed. And our leaders agree and think we are losing. This is madness on a grand scale.
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They get to produce and export, and we get to import and consume. Is this an unsustainable imbalance that we need to fix? Why would we want to end it? As long as they want to send us goods and services without demanding any goods and services in return, why should we not be able to take them? There is no reason, apart from a complete misunderstanding of our monetary system by our leaders that has turned a massive real benefit into a nightmare of domestic unemployment.
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the U.S. can ALWAYS support domestic output and sustain domestic full employment with fiscal policy (tax cuts and/or govt. spending), even when China, or any other nation, decides to send us real goods and services that displace our industries previously doing that work. All we have to do is keep American spending power high enough to be able to buy BOTH what foreigners want to sell us AND all the goods and services that we can produce ourselves
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We are not dependent on China to buy our securities or in any way fund our spending. Here’s what’s really going on: Domestic credit creation is funding foreign savings. What does this mean? Let’s look at an example of a typical transaction. Assume you live in the U.S. and decide to buy a car made in China. You go to a U.S. bank, get accepted for a loan and spend the funds on the car. You exchanged the borrowed funds for the car, the Chinese car company has a deposit in the bank and the bank has a loan to you and a deposit belonging to the Chinese car company on their books. First, all parties are “happy.” You would rather have the car than the funds, or you would not have bought it, so you are happy. The Chinese car company would rather have the funds than the car, or they would not have sold it, so they are happy. The bank wants loans and deposits, or it wouldn’t have made the loan, so it’s happy. There is no “imbalance.” Everyone is sitting fat and happy. They all got exactly what they wanted. The bank has a loan and a deposit, so they are happy and in balance. The Chinese car company has the $U.S. deposit they want as savings, so they are happy and in balance. And you have the car you want and a car payment you agreed to, so you are happy and in balance as well. Everyone is happy with what they have at that point in time. And domestic credit creation—the bank loan—has funded the Chinese desire to hold a $U.S. deposit at the bank which we also call savings. Where’s the “foreign capital?” There isn’t any! The entire notion that the U.S. is somehow dependent on foreign capital is inapplicable. Instead, it’s the foreigners who are dependent on our domestic credit creation process to fund their desire to save $U.S. financial assets.
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credit funding foreign savings. We are not dependent on foreign savings for funding anything.
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what options do foreign savers have for their dollar deposits? They can do nothing, or they can buy other financial assets from willing sellers or they can buy real goods and services from willing sellers. And when they do that at market prices, again, both parties are happy. The buyers get what they want—real goods and services, other financial assets, etc. The sellers get what they want—the dollar deposit. No imbalances are possible. And there is not even the remotest possibility of U.S. dependency on foreign capital, as there is no foreign capital involved anywhere in this process.
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Deadly Innocent Fraud #6: We need savings to provide the funds for investment. Fact: Investment adds to savings.
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this innocent fraud undermines our entire economy, as it diverts real resources away from the real sectors to the financial sector, with results in real investment being directed in a manner totally divorced from public purpose. In fact, it’s my guess that this deadly innocent fraud might be draining over 20% annually from useful output and employment—a staggering statistic, unmatched in human history. And it directly leads the type of financial crisis we’ve been going through. It begins with what’s called “the paradox of thrift” in the economics textbooks, which goes something like this: In our economy, spending must equal all income, including profits, for the output of the economy to get sold. (Think about that for a moment to make sure you’ve got it before moving on.) If anyone attempts to save by spending less than his income, at least one other person must make up for that by spending more than his own income, or else the output of the economy won’t get sold.
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“Savings is the accounting record of investment.”
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Congress, the media and mainstream economists get this all wrong, and somehow conclude that we need more savings so that there will be funding for investment. What seems to make perfect sense at the micro level is again totally wrong at the macro level. Just as loans create deposits in the banking system, it is investment that creates savings.
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what do our leaders do in their infinite wisdom when investment falls, usually, because of low spending? They invariably decide “we need more savings so there will be more money for investment.” (And I’ve never heard a single objection from any mainstream economist.) To accomplish this Congress uses the tax structure to create tax-advantaged savings incentives, such as pension funds, IRA’s and all sorts of tax-advantaged institutions that accumulate reserves on a tax deferred basis. Predictably, all that these incentives do is remove aggregate demand (spending power). They function to keep us from spending our money to buy our output, which slows the economy and introduces the need for private sector credit expansion and public sector deficit spending just to get us back to even.
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In fact it’s the Congressionally-engineered tax incentives to reduce our spending (called “demand leakages”) that cut deeply into our spending power, meaning that the government needs to run higher deficits to keep us at full employment. Ironically, it’s the same Congressmen pushing the taxadvantaged savings programs, thinking we need more savings to have money for investment, that are categorically opposed to federal deficit spending.
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And, of course, it gets even worse! The massive pools of funds (created by this deadly innocent fraud #6, that savings are needed for investment) also need to be managed for the further purpose of compounding the monetary savings for the beneficiaries of the future. The problem is that, in addition to requiring higher federal deficits, the trillions of dollars compounding in these funds are the support base of the dreaded financial sector. They employ thousands of pension fund managers whipping around vast sums of dollars, which are largely subject to government regulation. For the most part, that means investing in publicly-traded stocks, rated bonds and some diversification to other strategies such as hedge funds and passive commodity strategies. And, feeding on these “bloated whales,” are the inevitable sharks—the thousands of financial professionals in the brokerage, banking and financial management industries who owe their existence to this 6th deadly innocent fraud.
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Deadly Innocent Fraud #7: It’s a bad thing that higher deficits today mean higher taxes tomorrow. Fact: I agree—the innocent fraud is that it’s a bad thing, when in fact it’s a good thing!!!
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why does government tax? Not to get money, but instead to take away our spending power if it thinks we have too much spending power and it’s causing inflation.
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Why are we running higher deficits today? Because the “department store” has a lot of unsold goods and services in it, unemployment is high and output is lower than capacity. The government is buying what it wants and we don’t have enough after-tax spending power to buy what’s left over. So we cut taxes and maybe increase government spending to increase spending power and help clear the shelves of unsold goods and services.
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And why would we ever increase taxes? Not for the government to get money to spend—we know it doesn’t work that way. We would increase taxes only when our spending power is too high, and unemployment has gotten very low, and the shelves have gone empty due to our excess spending power, and our available spending power is causing unwanted inflation.
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So the statement “Higher deficits today mean higher taxes tomorrow” in fact is saying, “Higher deficits today, when unemployment is high, will cause unemployment to go down to the point we need to raise taxes to cool down a booming economy.” Agreed!
Part II: The Age of Discovery
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In those early 1970’s when I worked there, the Savings Bank of Manchester was one of those thousands of dull, boring savings banks that paid 5.25% to their depositors and financed homes with 8%, 30-year mortgages. We got to work at 8:30 am, and left to play golf (Or softball. My shoulder still isn’t quite right from trying to throw someone out at the plate from the outfield) around 4 pm. And in 1972, with a U.S. population of just over 200 million, these plain, dumb, boring savings banks financed 2.6 million new housing starts, with no secondary markets, no futures markets, and very modestly paid employees (I started at $140 per week, and had worked my way up to $200 per week as an investment officer).
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Today, with a population of over 300 million, a massive financial sector, untold financial innovations, and unlimited financial resources and liquidity, if we manage to get 2 million housing starts a year, it’s proclaimed an unsustainable bubble. More on that kind of “progress” later in this book.
Part III: Public Purpose
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Functions of government are those that best serve the community by being done collectively. These include: The military, the legal system, international relations, police protection, public health (and disease control), public funding for education, strategic stockpiles, maintaining the payments system, and the prevention of “races to the bottom” between the states, including environmental standards, enforcement standards, regulatory standards and judicial standards.
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the trade deficit is not a matter of the U.S. being dependent on borrowing offshore, as pundits proclaim daily, but a case of offshore investors desiring to hold U.S. financial assets. To accomplish their savings desires, foreigners vigorously compete in U.S. markets by selling at the lowest possible prices. They go so far as to force down their own domestic wages and consumption in their drive for “competitiveness,” all to our advantage. If they lose their desire to hold U.S. dollars, they will either spend them here or not sell us products to begin with, in which case that will mean a balanced trade position. While this process could mean an adjustment in the foreign currency markets, it does NOT cause a financial crisis for the U.S.
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right fiscal policy works to optimize our output, employment and standard of living, given any size trade gap.
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Nearly 20 years ago, Soft Currency Economics was written to reveal that government securities function to support interest rates, and not to fund expenditures as generally perceived. It goes through the debits and credits of reserve accounting in detail, including an explanation of how government, when the Fed and Treasury are considered together, is best thought of as spending first, and then offering securities for sale. Government spending adds funds to member bank reserve accounts. If Govt. securities are not offered for sale, it’s not that government checks would bounce, but that interest rates would remain at the interest rate paid on those reserve balances. In the real world, we know this must be true. Look at how Turkey functioned for over a decade—quadrillions of liras of deficit spending, interest rate targets often at 100%, inflation nearly the same, continuous currency depreciation and no confidence whatsoever. Yet government “finance” in lira was never an issue. Government lira checks never bounced. If they had been relying on borrowing from the markets to sustain spending, as the mainstream presumed they did, they would have been shut down long ago. Same with Japan– over 200% total government debt to GDP, 7% annual deficits, downgraded below Botswana, and yet government yen checks never bounced, and 3-month government securities fund near 0%. Again, clearly, funding is not the imperative.
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The U.S. is often labeled “the world’s largest debtor.” But what does it actually owe? For example, assume the U.S. government bought a foreign car for $50,000. The government has the car, and a non-resident has a U.S. dollar bank account with $50,000 in it, mirroring the $50,000 his bank has in its account at the Fed that it received for the sale of the car. The nonresident now decides that instead of the non-interest bearing demand deposit, he’d rather have a $50,000 Treasury security, which he buys from the government. Bottom line: the US government gets the car and the nonresident holds the government security. Now what exactly does the U.S. government owe? When the $50,000 security matures, all the government has promised is to replace the security held at the Fed with a $50,000 (plus interest) credit to a member bank reserve account at the Fed. One financial asset is exchanged for another. The Fed exchanges an interest bearing financial asset (the security) with a non-interest bearing asset. That is the ENTIRE obligation of the U.S. government regarding its securities. That’s why debt outstanding in a government’s currency of issue is never a solvency issue.
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Children as an Investment Rather than an Expense Anyone who pauses to think about it will realize that our children are our fundamental real investment for the future. It should be obvious to all that without children, there won’t be much human life left in 100 years. However, our current institutional structure—the tax code and other laws and incentives on the books—have made our children an expense rather than an investment. And a lot of behavior most of us would like to see not happen, including deficiencies in education, child neglect and abuse and high rates of abortion, could be addressed by modifying the incentives built into our financial system.
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About 10 years ago I was discussing the military with a member of the Pentagon. He said that we needed to increase the size of the military. I said
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that if we wanted to do that we should have done it ten years ago (1990) when we were in a recession with high unemployment and excess capacity in general. Back then, with all that excess capacity, a buildup of the military would not have been taking as many productive resources away from the private sector as it would have done during a period of full employment. He responded, “Yes, but back then we couldn’t afford it, the nation was running a budget deficit; while today with a budget surplus, we can afford it’. This is completely backwards! The government never has nor doesn’t have any dollars. The right amount of spending has nothing to do with whether the budget is in surplus or deficit. They use the monetary system which provides no information for all their information.
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statement—“the price level is a function of prices paid by govt. when it spends.” What does this mean? It means that since the economy needs the government spending to get the dollars it needs to pay taxes, the government can, as a point of logic decide what it wants to pay for things, and the economy has no choice but to sell to the government at the prices set by government in order to get the dollars it needs to pay taxes, and save however many dollar financial assets it wants to. Let me give you an extreme example of how this works: Suppose the government said it wasn’t going to pay a penny more for anything this year than it paid last year, and was going to leave taxes as they are in any case. And then suppose this year all prices went up by more than that. In that case, with its policy of not paying a penny more for anything, government would decide that spending would go from last year’s $3.5 trillion to 0. That would leave the private sector trillions of dollars short of the funds it needs to pay the taxes. To get the funds needed to pay its taxes, prices would start falling in the economy as people offered their unsold goods and services at lower and lower prices until they got back to last year’s prices and the government then bought them. While that’s a completely impractical way to keep prices from going up, in a market economy, the government would only have to do that with one price, and let market forces adjust all other prices to reflect relative values. Historically, this type of arrangement has been applied in what are called “buffer stock” policies, and were mainly done with agricultural products, whereby the government might set a prices for wheat at which it will buy or sell. The gold standard is also an example of a buffer stock policy.
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Today’s governments unofficially use unemployment as their buffer stock policy. The theory is that the price level in general is a function of the level of unemployment, and the way to control inflation is through the employment rate. The tradeoff becomes higher unemployment vs. higher inflation. To say this policy is problematic is a gross understatement, but no one seems to have any alternative that’s worthy of debate.
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All the problematic inflation I’ve seen has been caused by rising energy prices, which begins as a relative value story but soon gets passed through to most everything and turns into an inflation story. The “pass through” mechanism, the way I see it, comes from government paying higher prices for what it buys, including indexing government wages to the CPI (Consumer Price Index), which is how we as a nation have chosen to define inflation. And every time the government pays more for the same thing, it is redefining its currency downward.
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So for me, our biggest inflation risk now, as in the 1970’s, is energy prices (particularly gasoline). Inflation will come through the cost side, from a price-setting group of producers, and not from market forces or excess demand. Strictly speaking, it’s a relative value story and not an inflation story, at least initially, which then becomes an inflation story as the higher imported costs work their way through our price structure with government doing more than its share of paying those higher prices and thereby redefining its currency downward in the process.