Only Certain Types Of Deficit Spending Require An Increase In The National Debt
Deficit spending that restores a catastrophically reduced money supply does not require an increase in the national debt
By David Grace (Amazon Page — David Grace Website)
Private Citizens Cannot Create Money
Because you cannot print your own money, if you want to spend more than you earn you have to borrow the extra money, pay interest and, absent bankruptcy, eventually pay it back.
But, if you can print your own money, that is, if you’re the federal government, you can spend more than you earn, and that’s called deficit spending.
The Balance Between The Money Supply And Wealth
At any given point in time there is a balance between the country’s money supply (currency, savings accounts, checking accounts, certificates of deposit, etc.) and the country’s real wealth (houses, cars, land, machinery, businesses, etc.)
That balance between money and wealth determines how many units of money it takes to buy something.
If the government materially increases the supply of money without an offsetting increase in the nation’s non-money wealth, it disrupts the balance between the amount of money in the economy and the amount of real wealth in the country, thus causing the value of each unit of money to decrease, that is, people have to spend more dollars to buy the same thing — inflation.
To understand deficit spending and inflation you first have to understand what the money supply is.
What Is The Money Supply?
The total amount of money in an economy, cash, savings and checking accounts, certificates of deposit, money market accounts and the like is called the money supply.
Virtual Money
Today, only a small percentage of money (about 7%) is physical money — bills and coins. In the United States almost all money (about 93%) is virtual money, just numbers in banks’ ledgers.
The Supply Of Virtual Money Increases & Decreases On Its Own
Unlike the supply of physical money (bills and coins), which is static unless the government prints more, the supply of virtual money is dynamic and increases and decreases in proportion to increases and decreases in the economy and increases and decreases in the country’s actual wealth.
The Supply Of Virtual Money Operates like a Big Feedback Loop
Banks can borrow up to 90% of the amount of their deposits from the federal government at low interest and then loan that borrowed money to someone else.
If I deposit $1,000 in a bank account the bank can loan $900 to someone else. If that borrower then deposited their new loan in another bank account and that bank loaned 90% of that deposit and that borrower deposited that loan in another bank and that bank loaned 90% of that deposit etc. the original $1,000 I deposited in the first bank could increase the money supply by an additional $9,000.
Similarly, if those deposits were all withdrawn without the recipients of the money creating new bank accounts, the money supply would shrink by that $9,000.
As the economy improves more money is loaned and deposited and the money supply increases. When the economy declines, less money is loaned and deposited and the money supply decreases.
Because people borrow money using stocks as collateral, when the stock market goes up the value of shares of stock increases enabling new borrowing and the money supply increases. If the stock market crashes, the money supply decreases.
There is a feedback effect between the economy and the money supply so that moderate changes in the economy can be amplified as either large increases or large decreases in the money supply.
As the economy gets worse and the money supply decreases that decrease in the money supply has a feedback effect making the economy slow even more and that slowing further decreases the money supply and so on and so on.
To combat this feedback effect, the government raises or lowers the interest rate banks pay to borrow money from the Federal Reserve and those higher or lower the Federal Reserve interest rates either decrease the money supply and slow down the economy or increase the money supply and speed up the economy.
See the end of this column for a metaphor for how this feedback effect between changes in the money supply and changes in the economy works.
A Massive Reduction In The Money Supply
Let’s say that because of a pandemic a large number of businesses are closed and a material percentage of the workforce is suddenly out of a job. Nevertheless, all the costs of living still remain. People still have to buy food.
For a while people are able to pay their rent and buy food with their savings, but eventually all their savings are gone.
Because these unemployed people have no income or savings left, they can’t sell their assets for what they used to be worth because many people don’t have the money to buy them.
The banks don’t have any money to lend because so many people have withdrawn whatever savings they had and this loss of deposits causes the banks to call in their loans which no one has the money to pay.
Landlords don’t have any money because their tenants have stopped paying rent. Without the rent money the landlords have stopped paying their mortgages and the banks have foreclosed on their buildings.
Businesses can’t function because they have no money to pay workers or buy materials and their customers have no money to buy their products.
A huge portion of the money supply has evaporated. It’s gone. Without money the economy has died. Economists sometimes say that the economy has become frozen, like an engine that has been run without any oil.
The physical country is the same. The land is still there. The buildings are still there. The factories and stores are still there, the nation’s wealth is still there, but many people and businesses are starving or bankrupt because the economy has run out of money, like a human body dying because it has run out of blood.
Deficit Spending & Inflation
It’s been an article of faith that when the government wants to spend more than it takes in (deficit spending), in order to avoid inflation it needs to borrow the excess money by selling government bonds. The total outstanding amount that the government has borrowed is called the National Debt.
The problems with increasing the national debt are:
- (1) the government has to pay interest on the bonds, which decreases the amount of money it has available for other uses and
- (2) at some point the bonds will need to be repaid or refinanced.
But the simplistic idea that deficit spending always requires borrowing and a consequent increase in the national debt is false.
All Deficit Spending Is Not Created Equal
The assumption has been that all deficit spending has the same inflationary effect and therefore that all deficit spending must always be offset by government borrowing but, in reality, the inflationary effect of deficit spending depends more on what the government is spending the additional money on.
The Three Categories Of Deficit Spending
There are three general categories of deficit spending:
- Spending to create more national wealth — build infrastructure, create new technology, develop valuable natural resources, etc.
- Spending to return a money supply reduced by depression, catastrophe, pandemic, etc. back to its previous value
- All other deficit spending, e.g. wars, military hardware, welfare payments, etc.
Two Of The Three Types Of Deficit Spending Do Not Cause Inflation
- Deficit spending that creates an equal or greater amount of national wealth does not cause inflation because the increased money supply created by the deficit spending is offset by the increase it creates in the nation’s actual wealth.
- Deficit spending that returns a suddenly depleted money supply back to the level it held prior to the depression, pandemic, etc. does not cause inflation because the increase in the money supply only returns the money supply back to the same balance it previously had with the amount of national wealth.
- All other deficit spending will cause inflation proportional to the increase in the money supply in excess of the country’s national wealth.
Does The Deficit Spending Restore A Reduced Money Supply To Its Previous Level?
In 2019 the amount of physical money (currency) in the U.S. was about $1.5 Trillion. The amount of virtual money was in excess of $19.5 Trillion.
If the pandemic and the accompanying unemployment, foreclosures, bankruptcies and the like reduced the virtual money supply from $19.5 trillion to $10 trillion the government could distribute $9.5 trillion in new virtual money without causing any material inflation because that deficit spending would only restore the money supply back to its previous $19.5 trillion level that was in balance with the country’s actual wealth. That deficit spending can simply be ignored.
Does The Deficit Spending Increase The Country’s Actual Wealth?
If the deficit spending will create new actual wealth equal to or greater than the amount being spent, the expenditure will not have an inflationary effect and will not need to be offset by government borrowing. That deficit spending can simply be ignored.
For example, suppose the government creates $10 billion of additional money in excess of its tax revenues and spends that additional money to build a huge facility that will supply enough cheap water to turn those 20,000 worthless desert acres into rich farmland which will be worth $10 billion.
The money supply has been increased by the $10 billion in deficit spending, but $10 billion in new real wealth (new farmland) has simultaneously been created to balance the additional $10 billion the government added to the money supply.
In this case, the relationship between the country’s money supply and the country’s real wealth has not changed so there will be no inflation from the $10 billion in deficit spending.
Deficit Spending That Neither Increases The Country’s Real Wealth Nor Restores A Shrunken Money Supply
On the other hand, if the deficit spending will not be offset by the creation of an equal amount of new wealth nor will it return a deflated money supply to its previous level, the expenditure will have an inflationary effect unless it is offset by government borrowing.
For example, if the government created a new $10 billion account out of thin air and spent the money to hire an army of workers to dig ten million holes in the desert and then fill them up again, then, unless offset by borrowing, that deficit-spending increase in the money supply would be inflationary because it would not be offset by a corresponding increase in the country’s actual wealth.
Similarly, because military weapons and wars do not add any real economic assets to the country, deficit spending to finance the military will cause inflation unless there is an offsetting sale of government bonds.
On the other hand, because infrastructure such as roads and bridges, more efficient energy distribution systems, etc. do actually improve the economy and increase the value of the country’s physical assets, financing them with deficit spending will lead to much less inflation than deficit spending of the same amount of money to finance weapons, wars and welfare.
To Know Whether Or Not To Increase The National Debt You First Have To Understand What Type Of Deficit Spending The Government Is Proposing
So, deficit spending that does not cause inflation does not need to be balanced by borrowing and does not need to be reflected in an increase of the national debt. It can simply be ignored.
Deficit spending that does cause inflation does need to be balanced by borrowing and does need to be reflected in an increase of the national debt.
The trick is know which is which.
— David Grace (Amazon Page — David Grace Website)
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A Metaphor For The Relationship Between The Money Supply, National Wealth, & Inflation
We’re all familiar with the feedback effect that occurs when a microphone gets too close to the speaker. Let’s imagine a microphone and a speaker some distance apart with a small radio placed halfway between them.
If the radio’s volume is too low, the microphone will barely hear it and the speaker’s output will be too soft for the people at the back of the room to hear the music.
If the radio’s volume is too high, the microphone will pick it up too strongly and we will get unpleasant, screeching feedback from the speaker.
When there is a proper balance between (1) the volume on the radio and (2) the distance between the microphone and the speaker, then the speaker will amplify the music playing on the radio loudly enough for everyone in the room to hear the music, but not so loud that there will be feedback.
Let’s call the volume on the radio the Money Supply. The louder the volume coming out of the radio, the larger the Money Supply. The lower the volume from the radio, the smaller the Money Supply.
Let’s call the distance between the microphone and the speaker the National Wealth — fertile land, factories, technology, physical objects, infrastructure, etc. The farther apart the microphone and the speaker, the larger the national wealth. The closer the microphone and the speaker are to each other, the smaller the national wealth.
The radio is always halfway between the microphone and the speaker.
Restoring A Shrunken Money Supply
If the battery in the radio weakens and its sound output decreases, that is if the money supply decreases as a result of some change in the economy, you will need to turn up the volume knob on the radio to return the sound level coming out of the radio’s tiny speaker to its original loudness so that the big speaker will be able to continue to broadcast the music loudly enough for everyone at the back of the room to still hear it, that is, you will have to increase the money supply back to its original level to return the economy back to where it was before the money supply shrank.
Increasing The National Wealth
If you both (1) turn up the volume on the radio, that is, if you increase the money supply and also at the same time you (2) move the microphone and speaker farther apart, that is, if you increase the national wealth, the speaker will continue to broadcast the music at the desired level without feedback.
Causing Inflation
If you turn up the volume on the radio but don’t move the microphone and the speaker farther apart, that is if the government increases the money supply but without a corresponding increase in the national wealth, you will get undesirable feedback, that is inflation.
Borrowing To Avoid Inflation
To avoid that, you will need to hang a piece of insulation between the radio and the microphone to reduce the amount of sound that the microphone receives from the now louder radio. That insulation represents the government borrowing money in order to offset its deficit spending.
The Money Supply, Wealth & Prices Always Interact
The radio, the microphone and the speaker are always interacting with each other. The money supply and the amount of the nation’s wealth are always increasing and decreasing, and when they get out of balance you get inflation or deflation until they stabilize.
You’re always in a struggle to balance the distance between the microphone and the speaker on one hand (the amount of national wealth) and the volume from the radio on the other hand (the size of the money supply) so that you don’t (1) get too much amplification which results in feedback — inflation — or (2) too little amplification which results in the people at the back of the room being unable to hear the music — deflation.
Too much volume from the radio (increased money supply) or if the radio is too close to the microphone (insufficient national wealth) you get feedback that destroys the music the speaker is supposed to amplify — inflation.
Too little volume from the radio (reduced money supply) or if the radio is too far away from the microphone (increased national wealth) then the volume from speaker decreases to the point that the music is not loud enough for the people at the back of the room to hear it — deflation.
