It’s Complicated

Do Deficits Matter?

Yes, and Republicans should use process reform to tackle them.

by MARC JOFFE

Although fiscal austerity has been dismissed as “oldschool” in recent years, history shows that the alternative— fiscal profligacy—brings dangers, which often manifest themselves years or even decades later. Rather than tempt fate, Republicans should rediscover their fiscally responsible heritage and develop modern policies to limit waste and reduce the risk of future financial calamity.

Under Democratic President Woodrow Wilson, the national debt ballooned from $3 billion in 1913 to $26 billion ahead of the 1920 Presidential election. Fed up with war, recession, tax increases, and government mismanagement under Wilson, voters gave Republicans a landslide victory in that election.

A major Republican reform enacted by the 67th Congress was the Budget and Accounting Act of 1921 – the successor to a bill vetoed by Wilson in 1920. This measure created what is now the Office of Management and Budget and the Government Accountability Office, implementing the annual budget process and centralizing federal auditing.

Better financial management and a strong economy led to a steep reduction in the national debt during the 1920s, but the residual debt limited federal fiscal flexibility at the outset of the Great Depression. By the early 1930s, interest on the debt consumed about 30% of federal revenues, crowding out other types of spending and acting as a barrier to tax reductions. Franklin Delano Roosevelt restored America’s fiscal flexibility through default: devaluing the dollar and denying Treasury bondholders the option to receive payment in gold.

Later in the 20th century, growing federal debt led to further disruptions. Debt monetization during World War II was suppressed through federal price controls, exacerbating shortages of many consumer goods. When the price controls were finally released, a short period of

double-digit inflation followed. After fiscal and price stability returned in the Eisenhower and Kennedy years, President Lyndon Johnson’s guns and butter budgeting spiked federal deficits and touched off an inflationary spiral that became especially pronounced during the 1970s. Federal Reserve Chairman Paul Volcker, with the support of President Reagan, greatly reduced inflationary pressure by sharply raising interest rates, triggering a deep recession in the early 1980s. Unfortunately, some recent Republican leaders have lost touch with the party’s fiscally conservative legacy. President George W. Bush did not match tax cuts with spending reductions, while placing two armed conflicts and a Medicare prescription drug entitlement on the nation’s credit card. Under President Donald Trump, deficits were rising even before COVID-19 struck, despite a strong economy. Today, we are in a situation that has some parallels to the early 20th century. We once again have a Marc Joffe potentially crushing debt burden. The only reason that debt service is not crowding out other spending

Republicans should priorities is that interest rates are rediscover their fiscally being held well below historical norms. To avoid the normalization responsible heritage and of interest rates, the Federal Reserve develop modern policies is obliged to monetize federal debt thereby exacerbating inflation.to limit waste and Although we do not know reduce the risk of future whether the rapid consumer price financial calamity. increases of recent months will continue, we do know that inflation in some form has remained with us even after the Volcker tightening. Instead of consumer goods registering steady price increases, inflation has continued to be an issue in education, healthcare, home prices and other asset valuations. So, despite CPI changes of 2% or less in most recent years, many costs have continued to escalate faster, (cont’d on p. 14)

Do Deficits Matter?

It’s complicated…

by FARROKH LANGDANA

A sustainable Federal budget deficit used to be defined as being less than about 5% of GDP.1 Today, the budget deficit/GDP is over 13%! Disaster, right? Should we expect hyperinflation to be coming? The short answer is no. Keep in mind we were in the same ballpark during the subprime mortgage crisis (10-12% for the budget deficit/GDP ratio) and the sky did not fall on our heads. Why not?

Back in the day with large deficits and the massive printing of money, sure, hyperinflation was a real concern and possibility. But in the subprime mortgage crisis we had a unique situation. During this particular time of turmoil, the U.S. was still the “safest cave” on the planet.2 With all global economies “huddling in their respective caves” in the global housing crisis, we were in the best position. Consequently, massive global capital poured in and, to some extent, helped fund our budget deficit.

This inflow of foreign capital was not enough to get us through the subprime mortgage crisis. But we also printed grotesque amounts of money, known as Quantitative Easing (QE). In fact, initially the Fed injected $48 billion per month, and later, $24 billion a month from 2007-15!

But, despite all this, there was no notable change in inflation. Here is a very important point: Massive monetary infusions ONLY erupt into mind-numbing hyperinflations when the money is actually injected into the economy. If it just “sits there” within lending institutions, then...no inflation! For example, the 5,500% inflation rate in the

case of the Weimar Republic (Germany post-WWI), and the 41.9 x 1015% rate for the last month of the Hungarian Hyperinflation (1946), were due to the fact that the money that was printed was already thrown into circulation – they were finally paying teachers, troops, farmers, suppliers, government workers, etc., who had not been paid for months.3 The money was rapidly injected into the economy; in fact it was “already spent.” Ditto for Zimbabwe, Argentina, Brazil, Venezuela, and others. Those inflation rates are staggering and are possible because injecting money into the economy is comparable to a snake bite. The venom (for most snake bites) is only lethal if it goes directly into the blood stream (or soft tissue). If it does not, you live. (Please do not test this example, I am not a global expert on venoms, but you get the point.) The same is true with monetary creation and hyperinflation. If the massive infusion of money does not slip into the economy, then no hyperinflation. With today’s greater than 13% deficit/GDP ratio, and the federal Farrokh Langdana government’s huge infusion of money of over $3 trillion so far (perhaps going to maybe $8-10 Massive monetary infusions trillion or more), is there reason

ONLY erupt into mind- for concern? Not at all. Same story, larger numbers. But this time numbing hyperinflations we have a name for it: Modern when the money is actually Monetary Theory (MMT). injected into the economy. MMT basically works like this: In the subprime mortgage crisis, the massive printing of money did not bring about hyperinflation, as explained above. (cont’d on p. 14)

[1] Macroeconomic Policy: Demystifying Monetary and Fiscal Policy, Springer Press, Edition 3, Farrokh Langdana, page 35, for a description of the Dornbusch Model of Sustainability. [2] Visit my blog page (including videos) for several blogs on this subject. https://www.business.rutgers.edu/faculty/farrokhlangdanaand then scroll down for the blogs.

[3] The German rate is the annualized inflation rate, while that for Hungary is the rate JUST for the very last month of the hyperinflation (August, 1946)! Please see pages 134-48 of Macroeconomic Policy: Demystifying Monetary and Fiscal Policy, by Farrokh Langdana, Springer Press, Edition 3, for lots on this subject.