naked capitalism

We are going to feature a series of posts this week on the merits of the idea of using Federal deficits to stimulate an economy in severe recession or depression. The first offering is from DoctoRx, who writes at EconBlog Review:

Part I. INTRODUCTION

Robert Rubin’s home town of Miami Beach contains any number of hotels and apartment buildings, plus a movie theater that honor the progressive Presidents Roosevelt, especially FDR.

How ironic then that Mr. Rubin would end up as such a key person in the 1999 evisceration (Gramm-Leach-Bliley) of part of Roosevelt’s first major securities law, the Glass-Steagall Act of 1933. How further ironic – and tragic- that this Beach boy would help rebuild much of the entire financial structure of the United States on sand, as if he were still in his hometown, rather than on the granite of his adopted New York.

Economists have been struggling to deal with the crisis caused by the crumbling of much of what he encouraged to be built.

Some now believe that as in FDR’s New Deal, the U. S. should increase its governmental debt even more than is currently in the works. One recent essay by Dr. Edward Harrison was of special interest in that it argued that the private sector of America is so burdened by excessive debt that the government needs to take on more and more debt in response.

While I am sympathetic to much that is in this wide-ranging article, this argument merits comment.

Part II. Discussion of “The recession is over but the depression has just begun”

Dr. Harrison believes that a chronic “depression” state is underway, regardless of any “Fake Recovery” that he believes has begun. He states:

“This is the core of our problem-debt.”

Re the title, while a chronic depression may be underway, who really knows? How would that opinion, even if widely shared, justify major changes in policy which themselves have unpredictable effects for better or for worse, given all the uncertainties?

Is debt really the core of our problem(s)?

Focusing on private debt as the core problem may be analogous to focusing one’s attention on one species of tree within a much larger stand.

How can it be that in a democracy, if the people and their companies are too heavy with debt, the solution can be that their government–which is the people in another form and whose debts are therefore the people’s debts– should take on debt which is additional to the existing debts? (It would be somewhat different if the government borrowed the money to extinguish the debt.) Is this a case of circular reasoning? Dr. Harrison implicitly says no, first saying:

1. The government plays a crucial role here because of the huge private sector indebtedness. In the U.S. and the U.K., the public sector is not nearly as indebted.

The author does not present the data he is using to support this statement. Published estimates of net existing Federal debt plus the present value of future obligations are north of $50 trillion; with current revenues around $2 T, the government has a debt:revenue ratio of 25 or worse. How many companies, individuals, or aggregate private sectors have that indebtedness ratio?

Statistics I have seen suggest that private debt is not as much above 1959 levels as one would think, but that it is Federal debt and unfunded obligations that is vastly worse than 50 years ago. For example, the Fed reports (http://www.federalreserve.gov/releases/z1/Current/z1r-5.pdf) that the household sector has $67 T of assets and $14 T of liabilities. (I do not believe that the promised Social Security benefits are counted as household assets, and assuming I am correct, either household assets are thereby understated or the Federal liabilities estimated above are overstated.) Personal income is running about $12 T. So in the aggregate, is not the household sector healthier re debt:income (and probably debt:equity) than the Federal government?
I am excluding private business debt from this sort of comparison. Business can take care of itself. The proposal that all of us should indebt ourself either to each other or foreigners because some businesses may have too much debt does not resonate with me.

2. Dr. Harrison then introduces the following argument:

So while, the private sector rebuilds its savings and reduces debt, the public sector must pick up the slack. Why do I say must? It’s because of an accounting identity which comes from the financial sector balances model. Marshall Auerback says it best in a recent post:

Here is Mr. Auerback’s wording in bold:

We’ve said it before and we’ll say it again. As a matter of national accounting, the domestic private sector cannot increase savings unless and until foreign or government sectors increase deficits. Call this the tyranny of double entry bookkeeping: the government’s deficit equals by identity the non-government’s surplus.

So, if the US private sector is to rebuild its balance sheet by spending less than its income, the government will have to spend more than its tax revenue. . .

DoctoRx here.

Mr. Auerback was kind enough to provide references so I could learn about this model. Without making the argument for or against any particular level of government spending or surpluses/deficits, here are comments on the general argument for more government spending, to be followed by a discussion of the model.

1. A model is just that; it is not reality. Reliance on a value-at-risk financial model initially generated at J. P. Morgan helped create the recent/ongoing financial crisis. A more basic identity than the above one is the “Accounting Identity”, which says that profit is what is left after costs are subtracted from gross income. No evidence has been presented that in a $14 T economy, the costs of running the economy exceed $14 T. If in fact the economy is net unprofitable, then kicking the can over to our doppelganger, the Federal Government that the States created, will not change the underlying economics.

2. No model, however intriguing, can change the basic facts that a profitable individual, company, State, or private sector has the potential ability to repay with interest even a heavy debt load out of true ongoing economic profits. Absent proof that the private sector debt load is crushing in the aggregate, and with a bankruptcy system that allows crushing individual debts to be extinguished,why is it both fair and beneficial all of us should borrow more funds through the special purpose vehicle of our government because some unwise or unlucky borrowers and lenders are in a jam.

3. Theory aside, how strong is the empirical evidence, or even better what is the proof that increasing government annual and aggregate deficits are good things to add to the economic mix following large increases in both private sector and governmental debt?

4. Could the government either simply let creditors work things out with borrowers, or use at least moral suasion to encourage the debt-reduction process to move along as fast and fairly as possible, and why would that not be superior to adding more credits and debits to the system?

5. There are all the standard other questions about crowding out private borrowers, worries about excessive governmental debt leading to higher interest rates on that debt, fears of continued/renewed debt monetization, etc. There are also less standard theoretical arguments to the model, such as that is is arbitrary and even political to set up government and the private sector as the two sectors to compare financial flows between. In 1858 in the U. S., for example, perhaps the more relevant comparison was between the East, which sent capital to the developing West, while the Federal government was small and had little or no net debt.

Let us discuss the financial sector balances model in detail. From a post by Rob Parenteau, courtesy of Marshall Auerback:

The financial balance of any sector in the economy is simply income minus outlays, or its equivalent, saving minus investment. A sector may net save or run a financial surplus by spending less than it earns, or it may net deficit spend as it runs a financing deficit by earning less than it spends.

Furthermore, a net saving sector can cover its own outlays and accumulate financial liabilities issued by other sectors, while a deficit spending sector requires external financing to complete its spending plans. At the end of any accounting period, the sum of the sectoral financial balances must net to zero. Sectors in the economy that are net issuing new financial liabilities are matched by sectors willingly owning new financial assets. In macro, fortunately, it all has to add up. This is not only true of the income and expenditure sides of the equation, but also the financing side, which is rarely well integrated into macro analysis. (Emph. added in bold)

So what Mr. Parenteau is explaining is that just as the income-expenditures relationship balances, so must the “financing side”. But what if the private sector simply accumulates equity, which has no debt financing characteristics? No government intervention or new debt issuance has to occur.

In addition, the financing issues may be somewhat more complicated than one might think.

After all, the private sector has to debit its bank account to send the funds to the government in order to buy the debt. All that is really happening is that the private sector had cash, and now the government has the cash with some repayment terms.

Now, if the government had a special relationship with tall aliens with big heads who arrived from another planet To Serve Man, and these aliens divulged to the government and only to the government the ways to make the deserts bloom, eliminate illness, etc., then the government would be able to have a great return on investment from the borrowed funds. But that’s sci-fi.

There is of course direct monetization of the government debt. The prospect of more of that behavior costs taxpayers directly in the form of higher interest rates. The greater the governmental debt issuance, the higher the unnecessary interest rates will go for this and other reasons.

It is thus hard to see how this model, useful though it may be (click HERE for an academic discussion), can change the facts that absent monetization of its debt, the government withdraws the same amount of funds from the private economy that it borrows. Whether this borrowing is “good” or “bad” for the economy depends on what the government does with the money versus what the private sector would have done with it had the government not traded debt for cash.

There are infinite examples of real savings that add to the net worth of the private sector and do not become anyone’s liability. Consider obtaining enough milk to meet the needs of many children from a cow that eats free grass, building a cabin from logs cut from nearby trees, or building a bridge to create an important crossing point of a river.

Please consider these simple examples as fractals with regard to the complex American economy. In these examples, government is irrelevant to private wealth creation, and the private sector may be able to eliminate its debt to zero on its own with its profitable activities.

The private sector can be profitable while the public sector is simultaneously profitable. Or, both can be unprofitable. One can be profitable and the other unprofitable. Double entry bookkeeping is a convention and is not tyrannical. It allows for wealth creation, for equity accumulation.

The world of profit and loss is in concept a single-entry world. Click HERE and scroll down for an example of a service provider’s accounts kept in single- vs. double-entry form (when all the service provider really cares about is profit, which is not even shown) and finally for a summary of the uses double-entry system.

(This discussion has for simplicity ignored imports/exports, because the thinking expressed herein would be just as valid if we were talking not about the U. S. but about the United Countries of the World, where the trade balance of each country would be just as irrelevant as the trade balance of each State of the United States.)

A follow-up post will suggest unconventional approaches to get to a healthier economy as well as a healthier America.

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