Executive Summary
In the context of the role that debts and deficits play in overall economic policy, in this paper I focus on the philosophy known as “sound finance,” which includes adherents who believe that governments should seek to balance their budgets. I, however, take a different view, and believe that the role of government when dealing with budget deficits should be one of “functional finance,” which ensures that the policies implemented help to reach the overarching goals of macroeconomic policy (generally held to be full employment and price stability).
This paper attempts to show why the proponents of sound finance are mistaken by defining and unpacking a series of “myths” that are foundational to, or at least helpful to, convincing us that sound finance requires that governments run a balanced budget. Though not a complete list, following are the “myths” presented:
Myth 1: Governments are like households
Myth 2: Printing money to finance budget deficits is inflationary
Myth 3: Budget deficits/high debt lead to high interest rates
Myth 4: Budget deficits are unsustainable
Myth 5: Debt is a burden on future generations
To conclude, I offer some thoughts on the actual impact of monetary policy on the real economy, which I believe to be quite small. These thoughts include a brief discussion about how fiscal policy, once the nature of government debts and deficits is fully understood, can be a viable alternative to monetary policy.
Introduction
What do the following people all have in common: Warren Buffet, Seth Klarman (Trades, Portfolio), Bob Rodriguez, Rob Arnott (at this point you may be looking at the list and thinking, hmm, all value investors), Paul Singer (Trades, Portfolio), Angela Merkel, George Osborne, and Barack Obama?
The answer is that they all seem to believe in an economic philosophy known as “sound finance,” as witnessed by the quotations below. As Walker (1939) noted, “Sound finance is sometimes worshipped as an end in itself…sound finance means the observance of certain arrangements which have become sanctified by habit and tradition…its intrinsic value [is] taken as self-evident.” Effectively this group of people (some of whom are actually my friends) believe that governments should seek to balance their budgets.
In the last fiscal year, we were far away from this fiscal balance… All of America is waiting for Congress to offer a realistic and concrete plan for getting back to this fiscally sound path. Nothing less is acceptable. — Warren Buffet, 2012
We are talking about the underlying structural issues of the federal budget deficit…the long-term insolvency of the country due to the government having made (and continuing to make) massively unpayable promises for the future. — Paul Singer (Trades, Portfolio), 2013
Governments that run huge deficits, promise entitlements that will be next to impossible to deliver, and depend on the beneficence of foreigners to stay afloat inevitably must collapse. — Seth Klarman (Trades, Portfolio), 2010
I don’t see how financial markets do well longer term if you continue to erode the fiscal integrity of our financial system. — Bob Rodriguez, 2012
Our debt level will have to be brought down to a more reasonable level. — Rob Arnott A Swabian Housewife[wouldsay] youcannot live permanentlybeyond your means.
— Angela Merkel, 2008
Without sound public finance, there is no economic security for working people… in normal times, governments…should runa budgetsurplustobear downondebt.
— George Osborne, 2015
Small businesses and families are tightening their belts. Their government should too.
— Barack Obama, 2010
In contrast to this group I adhere to a school that takes a very different view of the role of government budget deficits. It is best summed up by the following quotation from a member of my coterie of long dead favourite economists, Abba Lerner.
The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound or unsound. This principle of judging only by effects has been applied in many other fields of human activity, where it is known as the method of science… The principle of judging fiscal measures by the way they work or function in the economy we may call Functional Finance. (1943)
In essence, Lerner is saying that government deficits should be judged only by the degree to which they help us reach the goals of macroeconomic policy (generally held to be full employment and price stability), rather than by some arbitrary measure such as not having deficits of more than X% of GDP. The latter is “sound finance;” the former is “functional finance.”
Of course, finding myself facing the luminaries listed at the outset leaves me feeling a little like Captain Redbeard Rum in Blackadder II,
Edmund: Look, there’s no need to panic. Someone in the crew will know how to steer this thing.
Rum: The crew, milord? Edmund: Yes, the crew. Rum: What crew?
Edmund: I was under the impression that it was common maritime practice for a ship to have a crew.
Rum: Opinion is divided on the subject. Edmund: Oh, really?
Rum: Yahs. All the other captains say it is; I say it isn’t. Edmund: Oh, God; mad as a brush.
So let me try to explain why I take a very different view of the role of debts and deficits, and hopefully convince you that I am not as “mad as a brush.” To do this I’m going to attempt to show why the proponents of “sound finance” are mistaken by laying out a series of “myths” (or, for the alliteratively minded, five fiscal fallacies).
Myth 1: Governments are like households
Perhaps the foundational myth of all believers in sound finance is that the government sector is just like a household. The intuition for this belief and its accompanying misunderstanding can be seen by examining the stalwart go-to of economists – a simple barter system.1
Let’s imagine that I own an awful lot of cows, and you are a particularly skilled maker of yurts.2 In return for some of my surplus milk and cheese, you agree to repair my yurt periodically and, should the need arise, build me a new one. All is fine with the world until I happen to attend a local village meeting where I uncover that you have made exactly the same deal with just about everyone else in the village (the butcher, the baker, and candlestick maker included). It occurs to us that even if you worked all of the hours available there is simply no way that you can ever hope to repair/build enough yurts for all of us. You have incurred an excess of private debt. This is clearly bad.
This simple parable tells us that the over-accumulation of private sector debt is a problem. I completely agree with this analysis. However, those in the sound finance camp then extrapolate this finding into realms that involve governments and their deficits. Sadly, they do so in an indiscriminate fashion, and therein lies the problem.
We need to distinguish between governments that are what we might describe as monetarily sovereign (by which we mean those that issue their own currencies, have floating exchange rates, and issue debt in their own currency) and those that lack such sovereign status. In the former category we find countries such as the United States, the United Kingdom, and Japan whilst the Eurozone is a prime example of the latter group. This distinction has a great bearing on how one should think about debt and deficits.
Those nations that enjoy monetary sovereign status can, in effect, borrow from themselves. They have the ability to create money and spend it – essentially ex nihilo. Thus they can’t ever be forced into insolvency. If this sounds a little like Rumpelstiltskin spinning straw into gold that is because it is. Such are the benefits that are potentially available to monetarily sovereign nations.
However, for both types of regimes public debt is still different from private debt. In fact, public debt is often the counterpart of private saving. To see this we need to do a little macroeconomic accounting. (Double jeopardy on the boredom stakes, I know, but try and stay with me here.)
Let’s start by stating that output can be thought of as consumption, plus investment, plus government spending, plus exports minus imports. This is known as the expenditure model of GDP.
Y = C + I + G + (X – M)
We could also take a different perspective (the income model of GDP) and say that all output is consumed, saved, or paid in taxes.
Y = C + S +T
Setting these two equations equal to each other gives:
C + S + T = C + I + G + (X – M)
Cancelling out terms and rearranging generates what is known as the sectoral balances:
(S – I) = (G – T) + (X – M)
This states that if the private sector wishes to save in excess of its investment, then there must be a government deficit and/or a current account surplus. If one were working with a closed economy (i.e., no foreign trade) then the government deficit would be the exact counterpart to any private sector savings surplus.
Now, one of the very many pleasing aspects about accounting identities is that they have to be true (by construction) and thus, unsurprisingly, when we look at the data we see exactly what we would expect. The private sector generally runs surpluses with the counterpart coming from the government’s fiscal deficits.
We can see that twice in the sample shown in Exhibit 1, wherein the private sector has run significant deficits with neither experience ending well. The first was the TMT bubble, when firms drove the private sector into deficit, and the second was the housing bubble with households driving the private sector into deficit. Both are examples of the dangers of debt accumulation by the private sector. However, the government sector has been accumulating debt over this whole period seemingly with impunity – contrary to the proclamations of the sound finance adherents.
