How money enters the economy through deficit spending
Guest post: From reader McWop who has been a constant for a number of years, aka Matthew McOsker, writes on:
How money enters the economy through deficit spending. A simple model for discussion.
When the government deficit spends here are the mechanics:
a) Government buys goods from some private entity, let’s say $1,000 worth. The government deficit spends to do this. They credit the private entity’s checking account to the tune of $1,000 (increases reserves by $1,000)
b) Government issues a bond for $1,000
c) Private entity’s checking account is debited $1,000 to buy…
On net, a financial asset of $1,000 has been added to the economy – the original reserves are still there!
In this spreadsheet I have created three scenarios, for the sake of discussion. Don’t worry where the initial $1,000 for each person comes from, do not consider one rich or one poor – this is for illustrative purposes only to see the mechanics. There is no foreign trade, nor any private borrowing. That is for another discussion. Treat each year as a a calendar year.
Example 1, the government runs a surplus, and makes zero purchases. Quite simply the surpluses drain the economy and essentially drive the private sector into debt. The government does not save surpluses in any account for a rainy day. Its a drain.
For Example 2, we add in government purchases which slows the drain.
In Example 3, we deficit spend, which adds money to the economy – there is more there to drive aggregate demand.
Deficit spending is our savings, it is NOT like a household budget.
Link to spreadsheet:
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mcwop
so far i don’t think you have said anything new… except perhaps new to the “deficits are evil” folk running the country, including Mr O.
the trouble is that when you expand this reasoning without limit you do run into inflation problems. the deficit spending needs to by limited to the amount of “real” productivity that it creates. just like private business borrowing.
however, if you know it, perhaps you can explain what happened in Germany after 1933 when, I think, an otherwise very bad man, de-coupled Germany’s economy from the international banks and bootstrapped it out of the depression.
oddly, this is very similar to the claim the hard right makes when they say it wasn’t the new deal but the war that ended the depression in American.
bootstraps are bootstraps. if you can end a depression by government spending, wouldn’t it be better to spend it on things we can use for something besides killing people.
Germany’s Weimar inflation happened because:
1) Germany owed their war debts in foreign currency. So they printed money, and then had to sell it en masse in the currency markets driving the value of their currency down. That is not a condition we face.
2) They had a productivity problem when Belgian troops occupied the Ruhr valley and production was cut off limiting the supply of all sorts of core goods like food driving prices up.
Zimbabwe – civil war eliminated most of their productivity.
Many other countries their is usually a currency peg involved.
Bottom line is we have no inflation problem at the moment.
WWII did contribute to pulling us out of depression.
In the end it is best to spend domestically, and not on the military. In the end, people in this country do not understand the basic mechanics.Many of those people are in charge.
Fowarded question from another reader to Matthew:
I can see someone asking: Why only $100 in taxes and not $250 as in
example 1 and 2?
His statement: The government does not save surpluses in any account for a rainy day. Well if it’s a surplus, then where is the money if the government did not save it?
It’s a drain on what?
Why is the government in deficit if it is sending out SS checks which is our money in T bills? (I’m surprised Coberly did not pick up on this.)
The amount of tax is not super relevant, just the end result of a deficit or surplus.
A the Federal level a surplus is simply a reserve drain as they debit reserves for tax payment. Essentially, the money is “destroyed”, and not held in any account. Very different than at the state or local level. It is an accounting entry.
I used SS as an example of government spending. Maybe I should have used paying people to fix roads. Either way, it is really the net result that counts, all receipts minus all expenditures result in a net deficit or surplus. The SS trust fund debt is not issued to the public, so no net financial assets are added. Good area for discussion.
Hi McWop,
It was me asking. I think for the general public this subject is important but needs more explanation. Thus, I was asking Dan these questions rhetorically as someone looking for fault in your argument suggesting that you add more discussion to your post.
Remember, many if not most reading your post only have their personal life experience with money and how it flows and where it comes from and how they should handle it.
Look at it this way. Try explaining where milk comes from to an inner city child that has no concept of a farm and cows. For me, my mom’s side of the family were dairy farmers. For the kids from the projects I counseled at camp…not so much.
So, I encourage you do expound on this simple model before you bring in more dimensions.
McWop,
Not to be difficult, but for clarity of others: a surplus is simply a reserve drain as they debit reserves for tax payment.
Your talking accrual accounting? At the kitchen table, before they go to H & R Block, they only know cash flow.
This is the reason the conservative is so effective in their arguments. They are conflating accural accounting with cash flow accounting intentionally to hide their desired policy results. They know the public mass majority only thinks in terms of cash flow.
The idea that the government is destroying perfectly good money and thus subtracting it from the overall total of cash (thus shrinking the money supply and increasing it’s value, driving down exports, causing job loss, leading to decreased consumption resulting in a depression leading the politicians to suggest we need more cutting because the deficit is too high) is just not something they would think of. I mean who assumes their money in their savings account is there to be destroyed?
Daniel, this is exactly why I tried to create a simple example so a layperson could begin to understand this. Hoping through the comments maybe we can refine the example. It is a very counterintuitive concept. In fact deficit and surplus should be re-named.
Even Al Gore was out talking about what we would do with our surplus some years back. You cannot do anything with it as it does not exist “physically”. And of course a surplus was never sustainable, and would turn to deficit after enough time passes – unless you maintain a trade surplus.
to be honest, i can’t make any sense out of McWop’s reply to me or Rdan’s
“Why is the government in deficit if it is sending out SS checks which is our money in T bills? (I’m surprised Coberly did not pick up on this.)”
hunh?
the government is in deficit because it spends more than it takes in in taxes, borrowing the difference.
Social Security as such has nothing to do with this. SS has been a lender TO the government, soon it will be getting repaid the money it lent. according to some people who don’t understand what they are talking about, that repayment means that SS is “contributing” to the deficit. NO. the deficit was created when the money was borrowed, by the Congress that borrowed it. Creative accounting does not change the actual facts.
the government sends out SS checks which are paid for entirely by the payroll tax, and the interest on prior payroll taxes that were lent to the government.
you need to keep “the government” separate in your mind from “social security” which is a legally separate entity. no one paid their Social Security tax with the idea that it was “revenue” for the general government, fungible funds to do anything they wanted with. The payroll tax is a dedicated tax, and legally all the money it collects MUST be spent on benefits only.
i hope some professor doesn’t leap out of the bushes here and explain to me that “technically…”
because “technically” the exceptions are inconsequential, and the “technical” misleading use of language by the keepers of the unified budget would probably get them sent to jail if they worked for Enron.
McWop,
I think the example is good. It just needs some more words to go with it.
I would note in the main post that government surplus actually means the money is going to be destroyed as in shredded/burned (as in furnace burned).
Heck, this could all tie into the discussion about whether the government creates money or the banks do when they write loans…later on in the chain of thought that is.
Also, the issue of $250 vs $100 just leave too big of an invite for someone to be argumentive. In a simple world, models explaining mechanics need to use the same values all the time or someone will say the model is wrong because you used to different values.
As far as the german inflation is concerned… one, there is no reason to suppose we might not create our own inflation… as we did in the 1970’s… different times, but unlimited printing of money for whatever reason is inflation by definition, though the “causes” of that printing may be different from one time to another.
i was asking about germany not because of the inflation, but because germany was able to end the depression by “bootstraps”. i don’t know if that involved printing money, or just creating demand by starting up the war economy, or just getting free of the international bankers. my point not being particularly relevant to McC’s case… except as an indicator that “depression” is an entirely avoidable situation with reasonable government policy.. policy not tied to the demands of bankers and bond holders.
Coberly, good comments on SS. I will update the chart to show a different type of spending so we do not confuse the issue.
70’s inflation was not because of deficits. You had foreign oil shocks, and Nixon left the gold peg, which was the right decision. but inflation is the deficit constraint. But we just ran trillion+ $ surpluses with low inflation, then we can look at Japan with large deficits and low inflation .
Daniel, the case of endogenous bank created money is a fun one – many economists don’t even believe in it – I do. That and trade surpluses need to be introduced. Heck if we can just get the mainstream media to understand this, because most do not.
Yes, trade surplus.
Now there is a cash flow concept our families at their kitchen table can understand. They get income by selling stuff to others.
The family (We the People) are selling stuff to other familes such that we have money left over after our expenses. (yes I know it’s about demand for our dollars and all, but…)
Cash flow accounting. It is where the minds of the masses lives. Not accrual where you can credit a debt and debit a credit.
Coberly, one thought is that this concept does illustrate the harm of cutting SS to close any “deficits”.
mcosker
i’ll take your word that it shows the harm of cutting SS to close deficits. but since in the world as it is today, SS doesn’t have any effect on the deficits, i’m not sure your showing doesn’t just muddy the waters..
as for the cause of the 70’s inflation, the people i read an believe don’t think it was the oil shock. without the money creation by the Fed, the oil shock would have produced recession, not inflation. and it was the determination by Volker to follow monetary policy forever that caused the Reagan recession in spite of Reagan’s deficit spending policy.
i am actually not in much disagreement with you are far as i can tell. except that your words leave open the idea of infinite printing of money at no cost. and of course confuse the SS situation.
Coberly, running deficits that are too big are only constrained by inflation, which in turn is controlled through higher taxes, and lower spending. The Fed can also have an effect by increasing the cost of bank created money.
Social Security does effect the deficit. The deficit would be larger without the payroll taxes – wouldn’t it? The number the government presents is the balance after all taxes SS, Medicare income – no?
The US has been taxing too little and spending far too much borrowed SS cash/money on war and fearful security. Utterly unproductive war and securing the empire must be paid with taxed cash/money collected the year it is spent.
If there is cash/money in savings above transactional motives to hold cash/money, and that cash/money is not being invested in the economy it makes no sense for the government to be a peddler of investment vehicles rather than a taxing sovereign.
Except to the GOtreaparty’s sponsors!
ilsm – I agree too much of our spending is on the military, and would be better directed domestically.
However, we are not in total deficit spending enough to get the economy back on track. We need to be running a deficit of nearly $1.5 trillion for another 3 years to get back on track.
mmcosker
no.
you are completely misinformed about the nature of SS financing.
SS benefits are paid for by the people who will get the benefits. the money is kept separate from the budget.
certainly if you cut payroll taxes and decided to pay for SS with government spending (borrowing) that would affect the defiit. but that is NOT the case now. it would be a disaster if it was the case. which is why i am fighting to try to keep it from BECOMING the case.
the fact that i have been trying to explain this for many years on AB and you don’t understand it at all causes me to despair.
Coberly, when SS has to hit the SS trust fund, what happens to the budget deficit? I think I get the accounting, but let’s look at the mechanics. When they hit the the trust fund, that will increase the deficit – won’t it – assuming the government is already running a deficit – They will need to print money, crediting seniors checking accounts, and issue a treasury bond at the same time….
mmcosker,
For 30 odd years, too much has been borrowed for war and tax cuts.
Eliminating the “demand” deficit does not require borrowing.
mmcosker
no. when SS “hits the Trust Fund” it will merely be getting paid back the money it lent to the government. by honest accounting that does not increase the deficit. the deficit was increased when the government borrowed the money.
and when the money is paid back, the government does NOT “issue” a bond. it redeems one.
i really really really do wish you would learn how SS works before you “explain” it to people who already hear enough lies and foolishness about SS.
When SS “hit the Trust Fund” it is kind of like paying off one credit card with another. Your total debt does not increase. It just shifts from one card to another.
This doesn’t require a “government” per se to work. As long as you have a single reserve holder of last resort, any money that leaves that reserve winds up flowing back there. That’s an accounting identity. The holder of that single reserve can then stimulate (or depress) the economy by simply encouraging or discouraging circulation. If the government manages the reserve, then the government can stimulate the economy by spending with or without taxation or borrowing, because the money is going to wind up in the single reserve. That’s actually a pretty neat explanation.
Since a free economy uses pricing to transmit information about supply and demand, inflation is just a natural consequence of economic growth. If you suppress inflation, you are suppressing growth. This has been one of the long term consequences of the fight against inflation and lack of growth since the late 70s, the last inflationary period. Inflation isn’t something mystical, it is just a signalling mechanism. (Pricing is how we know the government isn’t borrowing enough and there are no skills mismatches holding back job creation.)
Coberly, I am simply looking at the basic mechanics, and not trying at all to spread any misconception.I am all for SS, it is a great system. But, I am interested in the government accounting math, and how money enters the economy.
So I will boil my question down to this:
Over the years when SS payroll taxes exceeded benefit payments, did that reduce the overall deficit number reported by the government or not?
mmcosker
that turns out to be a trick question.
the way the government reports the “unified deficit” the money it borrows from social security is counted as “revenue” and this (in any case) reduces the amount of money it would.. other things being equal, which they are not… borrow “from the public.”
so it is claimed by some that SS “affects” the deficit. but “the deficit” in that case is an accounting fiction.
somewhere the government manages to keep track of the fact that it owes the money back to SS. so the money the government borrowed from SS increased the amount of money it owes. which in any honest accounting would mean it “increased” the deficit.
but even here they play games. “oh, they say, it increased the deficit.” implying that “it” is Social Security that increased the deficit. NO! Borrowing FROM Social Security increased the deficit.
We do not ordinarily borrow a hundred bucks from our grandmother and then run around telling everyone she “increased our deficit.”
you can play games with kiting checks, and history shows a government can run a deficit forever..if it keeps the size of it under control… but when you start using your fancy bookkeeping to claim either that you don’t owe the money you borrowed to the people you borrowed it from… or that the fact that you borrowed it from them means that they are guilty of increasing you deficit… then you are morally corrupt and almost certainly hopelessly confused in your accounts.
when you say you “boil your question down to…” you are assuming that your question can meaningfully be boiled down. it can’t.
Coberly, we may just be talking past each other. If the deficit equals our savings, then deficit spending to replace the trust fund assets adds savings back into the economy. Exactly what the trust fund was designed to do.
MM yes you are.
Dale is working from a different concept of ‘deficit’, one fundamentally (in my opinion) derived from equity and not in the pluses and minuses of what CBO and OMB count as “deficits”.
Under the rules of the game increases in Trust Fund year end balances score as ‘surpluses’ for ‘The Deficit’ while decreases in such balances score as ‘deficits’. This is true even if those balances consist of assets amounting to multiple years of cost.
It seems kind of odd that SS can and under current projections will be sitting on accumulated assets of something over $3 trillion and be in ‘deficit’. It is also pretty odd than SS can run years of cash flow negative conditions and still be in ‘surplus’. And if you really want odd consider that in the last years before projected Trust Fund Depetion SS will be strongly cash flow negative AND running large deficits only to have both of those go right to zero at the moment of ‘bankruptcy’. That is under one reading of current law Social Security immediately stops being a cash drag on Treasury, no longer contributes to deficits on an annual basis and no longer contributes to Debt Subject to the Limit on the same day that it has to slash benefits by 25%. Oh and by that same token wiping away some $17 trillion in ‘unfunded liability’.
That is whether you use the metric of ‘deficit’ ‘cash flow’ ‘debt’ or ‘unfunded liability’ Social Security will never be more ‘healthy’ from a General Fund perspective than the day it defaults on scheduled benefits.
On the other hand under conditions of ‘sustainable solvency’ where Social Security would theoretically be able to pay out all scheduled benefits and permanently maintain reserves at their mandated level it would at one and the same time be in permanent surplus, permanently cash flow negative, and adding to Debt Subject to the Limit each and every year.
“The Hell you Say Webb! Bleeding cash, adding to Federal Debt each year, yet both permanently solvent and permanently running surpluses!! Surely you are talking CRAZY?!!”
To which I say “Don’t call me Shirley” and “that is the way the numbers would run”. Let’s just say that ‘balancing the family checkbook’ ‘making payroll on your small business’ are not useful models for understanding SS finance as it plays out on paper. Nor are common sense understandings of ‘deficit’ or ‘debt’.
on the other hand
if you don’t insist upon calling “volume” in the chemsitry lab “text books” on the one hand,
and cataloguing your library by cubic centimeters
the actual financial transactions are pretty simple.
SS collects a payroll tax and uses the money to pay benefits. anything left over is put in a Trust Fund (that can only be used to pay benefits). while waiting to be needed that “surplus” is invested in United States Bonds… which means the money is borrowed by the government and spend on what the government “needs” but NOT Social Security.
this is no different from the government borrowing money from China, Pete Peterson, or your aunt mae buying you a Savings Bond for your third birthday.
you can look at the books of Social Security all day for a year and never encounter the confusion that Bruce is describing.
and you CAN look at the books of the government and not encounter any real confusion as long as you understand that for some purposes the government keeps a set of books in which the money it borrows from social Security is counted as “revenue” and decreases the amount of money it has to borrow “from the public.” which of course means that when the government has to repay Social Security, it must (other things being equal) have to borrow more “from the public.”
if what you care about is money you have to borrow from the public, this way of accounting “the deficit” makes sense.
until you try to fold it into the “does social security contribute to the deficit/debt?” question. then, unless you keep track of what you are talking about your thinking goes all to hell.
it’s like trying to solve a problem in algebra (or physics) while letting “x” stand for two different things at the same time.
i hate it when people confuse themselves into absurdity and then proudly proclaim that absurdity is “the technical truth.” it’s not.
Social Security is paid for from the payroll tax. it does not borrow money. It does not contribute to the deficit or the debt… as those words are understood by normal human beings, which is who has to understand this stuff. don’t count on the professors: they are still telling the story of Achilles and the Tortise as if they were in possession of some secret knowledge which us poor “laymen” just can’t understand.
and the evil of all this is that if they can confuse the people about “ss contributes to the deficit” it will be much much easier for them to “fix” it, by cutting it.
cutting it will not reduce the debt or the deficit… except to the extent that money not paid to retired people can then be used for, say, defense spending.
since the debt doesn’t ever have to be paid back… this would work out just fine for them. not so fine for older people. and the “technical” word for it would be stealing. or embezzeling the Trust Funds.
coberly,
In the unlikely event that SS were to “disappear” with a positive balance in the Trust Fund, is there any provision in current SS law on the disposition of those funds?
Critter
i don’t know. but it won’t “disappear.” it will just cease to be a meaningful retirement insurance program.
i beiieve that the SS Trust Fund can continue to rise indefinitely without being “paid back,” just as the “national debt” never needs to be paid back.
what counts is that actual income is sufficient to pay current expenses, including interest expenses… which are negative in the case of SS, since the Trust Fund is money that is owed TO SS.
both of these scenarios are of some advantage to the folks who keep the budget(s), and are subject to considerable political misrepresentation by folks who stand to gain politically by playing with ordinary people’s concepts of “debt.”
which comes down to me saying don’t worry about the Trust Fund. it is not important. it will either “run out” requiring an increase in the payroll tax (already past due) of not very much and no more than is a fair cost of the insurance that people are paying for. OR it will not run out, but increase to keep up with its function of providing a “reserve” for SS in case of periods of low revenue relative to needs for paying benefits. Since this is just a case of the government paying interest on money it borrowed but doesn’t have to pay back the principle… see national debt: it works the same way … it’s not a big deal.
it could have been a big deal in the case of the “low cost” projections of the Trustees, because it could have grown exponentially producing some scary numbers if not actual scary facts.
Bruce Webb likes to talk about the counterintuitive consequences of the play between the Trust Fund and the Budget. It does not seem to him that when your assumptions lead to nonsense, it is time to examine your assumptions.