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The public narrative is awash with proclamations of fiscal doom and the horror of the debt burden we're casting upon our children.  Our pundits, our elected leaders, Republicans and Democrats alike tells us we are on an unsustainable course and we cannot afford to keep borrowing from China to support our spending. Everyone from Pete Peterson, Erskin Bowles, and Mitt Romney to President Obama himself would have you believe this, and I'd like to explain that either they don't understand the nature of our monetary system, they don't understand monetary flows in our economy, or they are simply lying. Modern Monetary Theory can instruct us on the real nature of these issues and perhaps help bring about an economy that works for all.

The first thing to understand is the relationships that tie taxes and money to the economy. Prior to 1971 the US Dollar was backed by gold, and foreign holders could demand redemption in gold. The "gold window was closed to Americans, and in 1971 Nixon closed it altogether when he took us off the gold standard and allowed the dollar to float. Since then the Dollar has been a sovereign currency. It is not convertible and it is not redeemable, it is a unit of account.  It can only be obtained de novo in exchange for goods and services provided to the government either directly or through proxies such as social security. The power of money as a unit of account derives from the power of the government to impose taxes fines and fees and demand payment exclusively in dollars.  It is a monopoly, and practically everyone NEEDS dollars.  

You're probably wondering why, if the government just creates money when it spends, then why do we have all this debt? Get ready, this one might piss you off a little. The bottom line is the government sells its bonds in order to keep the interest rates up. UP! When the government spends and when the general economy is producing a monetary surplus, bank reserves go up and interest rates go down. Basically, when cash is easy to come by, you're not going to pay much for its use. So the Fed comes in and sells bonds to soak up the excess cash. When money gets tight in the economy interest rates are driven up and the Fed buys back the bonds pushing cash back into the economy. It's got nothing to do with government procurement. It's all about supporting the rent in financial assets, ultimately at the expense of real assets.

With these preliminaries out of the way, we can move on to the deficits and the economy. This involves some simple alegbra, but even more than that, it requires that you set aside what you think you know, and follow. If you're game, join me below the low-hanging orange apparition.

The following description borrows heavily from Dr. Stephanie Kelton at the University of Missouri Kansas City and Levy Economic Institute. For the sake of discussion we'll limit this to a closed economy. The addition of foreign trade imbalances adds nothing to this initial discussion. If there is interest I will cover that in a subsequent diary.

We begin with the simple identity for GDP in a closed economy where:

Y = GDP = National Income
C = Aggregate Consumption Expenditure
I = Aggregate Investment Expenditure
G = Aggregate Government Expenditure

[Eq. 1] Y = C + I + G
Once earned, income can be allocated in one of three ways. At the end of the day, all income (Y) will be:
(C) spent,
(S) saved or  
(T) used in payment of taxes:
[Eq. 2]  Y = C + S + T
Since they are equivalent expressions for Y, we can set equation [1] equal to equation [2], giving us:
C + I + G = C + S + T
Aggregate Consumption Expenditure (C) appears on both sides. It cancels from both sides and, rearranging terms, we have:
[Eq. 3]   (S – I) = (G – T)
Private Sector Savings (S) minus Private Sector Investment (I) = Aggregate Government Expenditures (G) minus Taxes (T)

Equation [3] shows that there is a direct relationship between what’s happening in the private sector (S – I) and what’s happening in the public sector (G – T). But it is not the one that everyone thinks. Quite the contrary . . .

To understand the argument, imagine a balance scale (like the scales of justice) with you representing the private (non-federal) sector on one side, and the public (federal) sector on the other.

Your financial status is given by (S – I):

If (S = I), your budget is in balance, you are neither net saving nor net borrowing
If (S < I), your budget is in deficit, your financial status is negative and you are net borrowing,
If (S > I), your budget is in surplus, your financial status is positive and you are net saving.
Uncle Sam’s financial status is given by (G – T):
If (G = T), his budget balanced
If (G > T), his budget is in deficit
If (G < T), his budget is in surplus.

There are only three possible outcomes when these factors interact.

In the first case there can be balance on both sides where ( S-I = 0 ) and ( G-T = 0 ).
The federal budget is in balance and there is no net savings or borrowing.

In the second case,  G > T represents net federal deficit spending. But note that G-T will be positive! Equation [3] tells us  (S – I) = (G – T).  If (G-T) is positive, (S-I) is identically positive and there is net private savings.

In the third case,  G < T represents a net federal budget surplus. But note that G-T will be negative!  Equation [3] tells us  (S – I) = (G – T).  If (G-T) is negative, (S-I) is identically negative and there is net private borrowing.
It's a pretty discouraging proposition. We are all hell bent deficit reduction and it can only harm the economy. And the real horror of it all is that what we call debt on the federal ledger is largely welfare for the holders of financial assets, and has nothing to do with jobs or production.  Spending money into existence does not produce debt. It produces a bookkeeping entry. Failure to spend it into existence is what will crush our economy as history has revealed as recently Clinton's "Goldilocks" era of budgetary surplus and rising private sector debt.

Originally posted to Old Surgeon on Sun Oct 07, 2012 at 11:46 AM PDT.

Also republished by Money and Public Purpose.

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