Economists recognize a limit on government spending due to the sources for the spending for those dollars to be spent. Economists call this limitation the “government budget constraint.” We recognize that there is a tax to be paid one way or the other, different ways of raising the funds implies different taxes. Some of these are up front taxes, where we know we are being taxed, while others are hidden taxes that we pay, nonetheless.
Indulge me to some simple math. Let’s use “G” for Government Spending, ”T” for Taxes, and “D” for Deficit. The Deficit, D, is, of course, just G-T, so D = G-T. That part is obvious: the part of government spending that exceeds the taxes raised to pay for that spending is the deficit (government debt on the other hand, is the deficit accumulated over the years minus the few surpluses we have had).
So, the excess of government spending over above the taxes to pay for that spending is the deficit. A hallmark of Keynesian economics has been the idea that deficits are ok, that they are even a good thing during recessionary periods. This approval of deficit spending by the federal government removed the moral constraint to not run deficits that had been in play for years.
Borrowing to pay deficits and taxes on capital and labor
The next question is “how do we pay for this deficit?” Well, of course, we borrow the money–we choose to increase our debt by borrowing from anyone who thinks that we are credit worthy, better risks than others at the interest rate we are paying. We simply put IOUs (or treasury bills) up for sale. Some of the creditors or buyers of these IOUs are our own citizens, and some are not.
If we only sell our IOUs only to our own citizens, we soon have to lower the price of our IOUs in order to sell more, as there will be a point where the our citizens will start to have to take their funds from investment projects in which they are willing to invest and keep those funds in treasuries, or government IOUs. While I will not go into the explanation in this post, interest rates and the prices of IOUs go in opposite directions, but here is a sufficient explanation from About.com.
As we drop our price to sell more, our interest expense increases. So, as we increase the size of our debt with deficits year after year, we also drive up interest expenses for most of the debt we owe, as much of it is in short-term securities. Since interest payments amount to part of our G, government spending, the deficit goes up at an even faster rate.
Of course, we sell our IOUs not only to our own citizens, but to all those around the world. By selling them to those outside our borders we are able to raise more funds at the same interest rate as compared to only selling them domestically. Still, as our debt creeps upward, we have a larger proportion of our spending going to pay the interest on this debt. Since so much of our current debt obligations are in short-term obligations, new debt from additional deficit spending raises our interest expense on most of our debt. As more borrowing to finance new deficits begin to push interest rates up as the default risk on these funds increases (just like a lender runs a higher risk of not getting his funds back from someone who owes ten times what they make in a year compared to someone who is now debt free, but once had a mortgage), and so, lenders must get higher rates to take the risk of making the loan.
Interest rates start to edge upward as it becomes more difficult to sell our IOUs. Higher interest rates mean fewer business investments in machinery, equipment, factories, etc. will be worth making and less of these tools will be available for workers to use. Less capital per worker means lower productivity for workers and less pay, as workers are ultimately paid because they are productive. If the worker does not produce as much, the worker cannot be paid as much.
So, increased borrowing is a tax on workers and owners alike, as lower wages for workers and less capital held by owners harms both of these producer groups. This tax is hidden from immediate view, as it is not obvious that excessive government spending is immediately coming out of their pockets. The tag line for our blog, “what is seen and what is unseen” becomes important here, as people usually perceive taxes that they get a bill for as a tax, but they don’t see deficits as taxing them. As Louisiana Sen. Russell Long was noted for saying, voters really mean “Don’t tax me and don’t tax thee, tax the man behind the tree.” We are the men behind the tree. Or, when it comes to taxation, as Walt Kelly’s Pogo said “We have met the enemy and he is us.”
Printing money to pay the deficit and the inflation tax
Now one of the tricks that governments have used in the past is to have its central bank (our Federal Reserve) become one of the creditors and buy up these IOUs. In an earlier day, we would simply have some institution print or coin money. Increases in the supply of money in an economy usually or eventually results in raising prices, in inflation. If the increased money supply causes people to reduce their acceptance of the money involve as they expect the money to have a declining value,
The unstable Weimar Republic, the post-WWI German government, did exactly that, resulting in inflation rates that boggle the mind, reaching a rate of 100% every 2 days. In other words, prices were doubling every two days for a while.
Another way of thinking about that is that a person’s savings in money fell in half every two days. There is an often-repeated story of someone choosing between a huge prize and a penny payment that doubled every day for a month (30 days—we won’t get greedy here). Imagine getting a million dollars in 30 days or the penny payment doubling every 30 days. Here is a little article on that choice. The doubling penny ends up being $5,368,709.12 in just 30 days.
Now imagine the reverse, where you start off with cash holdings of $5,368,709.12, and you face inflation of 100% every two days. In only 60 days the buying power of your cash holdings is reduced to a single penny. In those short 60 days, the government’s inflation policy, turning its debt into money, has taxed away over $5 million of your savings. “My father was a lawyer,” says Walter Levy, a German-born oil consultant in New York, “and he had taken out an insurance policy in 1903, and every month he had made the payments faithfully. It was a 20-year policy, and when it came due, he cashed it in and bought a single loaf of bread.” (From the PBS series, Commanding Heights )
While everyone may try to rid their portfolios of money assets, it cannot be done for the whole economy, and so, wealth held in dollar assets falls, making us all poorer, but also making the inflation tax even higher. As people try to protect their portfolios by buying real assets (not money or dollar denominated IOUs), we end up in a game of “who gets stuck with the worthless money.” We spend that money at a faster and faster rate. For instance, the German hyperinflation mentioned above led to retailers raising their prices several times a day. Workers and their spouses soon started demanding to get paid several times a day so that the same marks were going around the economy at faster and faster rates. A very old and well known relationship in economics is that the price level (think CPI) times the output of real goods and services produced (think real GDP) equals the Money in the system times the speed at which money circulates (something called Velocity). Or, put another way, the growth rate in the Money Supply times the growth in Velocity divided by the growth in the economy is the growth in prices better known as inflation. Either more money or faster circulating money will drive up prices if we don’t increase our output.
We see store owners and farmers raising prices and seldom think that it is really the government and the central bank behind these price increases, making inflation amount to an invisible tax eroding away at the cash savings we worked years to build up.
I should point out that economists recognition of a government budget constraint, that we are taxed one way or the other for all of our spending is noted in the acronym “TANSTAAFL,” standing for “There Ain’t No Such Thing as a Free Lunch,” coined by Robert Heinlein in his science fiction book, “The Moon is a Harsh Mistress.” Still earlier, David Ricardo noted the equivalence of taxing and borrowing in his 1820 “Essay on the Funding System.”
Why Do Deficits Matter?
If we are taxed one way or the other as has been shown, why do deficits matter, why should we care about deficits and running up big national debts?
Well, just as Ricardo noted the monetary equivalence between borrowing and taxing to pay for some large government expense, such as a war (Ricardo’s example), Ricardo also suggested ways that these were not the same, noting that people often fail to perceive the full costs of government spending when it is financed by borrowing, noting what has been called by one of my professors, James Buchanan, “Fiscal Illusion.” The problem is that the taxpayer-voter seldom notices the perpetual interest payment the government must make as the same as the immediate tax increase to avoid a deficit.
Another way of putting this is that not all taxes are seen as such. People seldom connect the inflation that they face because of government services that they receive while refusing to pay higher taxes. People also do not notice that they have less equipment and tools at work and fewer sellers in each industry because investments were not made at some earlier time because interest rates were too high.
Taxes out of their own pockets are seen and kept to a minimum, while government benefits they get are seen and kept to a maximum. On the other hand, stealth taxes on capital and on money holdings are not seen as payments for their government benefits or the reductions in taxes for which they themselves are liable.
So, voters ask for lower taxes and higher benefits, more spending, and their representatives oblige. The cost of government is perceived as being very low. When we do not see the full cost of something, we usually ask for more, just as the consumer who does not pay for the environmental costs of the products they consumer want more to be produced.
Deficits matter because they misrepresent the true costs of decisions to voters. Voters who benefit from the spending vote for it, as it is clear that they benefit. Voters who pay the inflation tax or the capital tax (higher interest rates) do not perceive their liabilities and do not try to block passage. The most popular legislation, then, raises deficits. Fiscal Illusion that plagues us, especially when we employ deficit financing of government spending, makes continued deficits more likely, as voters, more than Twist, find it easy to ask for “More, please.”
-MC
