How to “Solve” the Budget Deficit

How to “Solve” the Budget Deficit

It all comes down to which lens you look through.

By Thomas E. Nugent

A

nugget: “The further [a] problem was from a solver’s expertise, the more likely he or she was to solve it. It

turns out that outsiders look through a completely different lens.”

Economists take note. If you are a monetarist or a Keynesian, or maybe even if you are a supply-sider, you

might be among those who view the current budget deficit as either a critical problem now or in the near

future. Traditional solutions to this perceived dilemma require reduced government spending, increased

taxation, or some combination of the two. Unfortunately, by attempting to reduce the budget deficit in such

ways, economic activity also will suffer — meaning that by solving one problem, we’d be creating another.

Maybe it’s time we look at this situation through the outsider’s lens.

A few years back, traditionalists said that paying for the Iraq war would result in bigger budget deficits and

rising interest rates, which would crowd out private investment. Yet, here we are — four years later — with

low interest rates, rising investment, a booming economy,

Then Hurricane Katrina hit, after which President Bush announced a plan to spend $200 billion to rebuild

the ravaged Gulf Coast. The opposition responded that the resulting larger budget deficit would penalize

future generations and drive interest rates higher. Some politicians even wanted to cut spending, postpone

tax cuts, and raise taxes to pay for the hurricane damage. Yet here we are — one-and-a-half years later —

with lower interest rates, a growing economy, rising incomes, and mounting wealth via record highs in the

stock market.

These failed forecasts have done nothing to encourage their purveyors to alter their thinking. Even Federal

Reserve chair Ben Bernanke suffers from budget-deficit nearsightedness.

Bernanke recently spoke extensively about the risks of a growing budget deficit, and of how it could

precipitate federal insolvency and slow economic growth as investment is crowded out. Fortunately,

Bernanke’s forecasting of Armageddon is based on the same traditional approach to fiscal policy practiced

by many of today’s deficit hawks; it’s an approach that is easily refuted, as problem-solvers viewing the

situation through an outsider’s lens might attest.

Essentially, there is no relationship between budget deficits and insolvency. In fact, as former Fed

chairman Alan Greenspan pointed out, with a floating exchange rate, there is no such thing as federal

insolvency. Rather, the problem is the risk of future inflation caused by excessive federal-government

demands on the private sector. But somehow Bernanke, our top inflation fighter, overlooks this fact,

focusing instead on nonexistent insolvency risks.

This insolvency issue is not unlike the accusation that, unless something is done, the Social Security

system will go bankrupt. Again, one must understand how the U.S. government functions in a

floating-exchange-rate environment.

In effect, fiscal policies — i.e., spending and taxation — are not constrained by some fixed asset, such as

the gold in Fort Knox. This

standard. But today the federal government can write as many checks as it desires, with the only limitation

being the inflation risk created by excessive demands on the private sector.

As an example, the federal government writes checks to construction companies for aircraft carriers, just

as it writes checks to Social Security recipients in retirement. These entities then deposit their checks at

local banks. When each check clears, the Federal Reserve credits the local bank’s reserve account at the

Fed, after which the local bank credits the corporate or individual account with what is known as “good”

funds.

Operationally, virtually all of the federal government’s “spending” consists of the Fed crediting an account

— that’s it. So essentially, there is no distinction between printing money and not printing money. Similarly,

there is no federal “box of money” which receives tax collections and the proceeds from new Treasury

securities, with these proceeds then available for use by the government through spending or lending.

Think about this: If you pay your taxes in actual cash, the government shreds it; if you pay by check, your

bank balances are reduced by that amount. Either way, the federal government receives nothing of value!

The critical point here — the outsider-looking-in point — is that the entire government spending process is

not constrained by government “revenue.” Whether or not the government has collected taxes, or

borrowed money from individuals here or abroad, such activities do not factor into the payment process.

Any constraints on that process are self-imposed, such as when the government sets a debt ceiling.

Meanwhile, federal government checks will

checks. This should come as a relief to Social Security recipients: The U.S. government is not going broke

and it’s not about to stop making Social Security payments.

The idea of “paying for” Social Security or Medicare or Medicaid — the supposed major culprits

contributing to future increases in the budget deficit — is

consequences of the many proposed solutions to this “looming,” though non-existent, crisis. The

tax-increase solution will constrain economic growth; so will the spending-reduction approach. In other

words, the gloom-and-doom forecasts of Ben Bernanke may indeed come true, but only because the cure

is worse than the disease.

Our top inflation fighter should stick to what he is supposed to do best — minimize the risk that inflation

becomes a real threat to economic growth. Meanwhile, Congress can do its part by lowering stifling

regulations, structuring taxes to encourage increased output, and reducing restrictive tariff barriers to lower

the cost of goods and services. These are the essential elements of a plan that will keep the mythical Grim

Reaper of insolvency in check.

That’s the lens I’m looking through today — one through which the future still looks very bright. Grim

Reapers, darkness, doomsdays, and bogeymen — that’s what you see when peer through the outdated

lenses used by way too many of our current public officials.

recent Wall Street Journal article about problem-solving contests contained this interesting littleand a shrinking deficit.had been the case prior to 1971, when the U.S. was constrained by the goldnever bounce unless Uncle Sam decides to bounce its ownnot the issue. The real concern is the economicNational Review Online - http://article.nationalreview.com/?q=ZTE4ZGE5OTM5OTc5NjQwNTg5ZjMzOGM3MGE1NzMwNjQ