Problems With Fiscal Stimulus -Inflation
(This is the Second Segment in a Three Part Series)
The United States has the ability to create and spend far more money than it collects in tax revenue by financing the deficit with Treasury Bonds. But how does the U.S. government use these to pay its bills once expenses exceed revenues?
· Method №1: The U.S. Treasury issues a United States Treasury Bond; the Bond is purchased by an individual, a corporation, a government or some other legal entity; then the money from the sale of the bond is deposited in the Treasury’s account and used to pay expenses. The bond is backed by the full faith and credit of the United States. In other words, it is not backed by gold, silver, or any other collateral. It is an unsecured obligation of the United States government.
· Method №2: The U.S. government simply loans money to itself: The United States Treasury Department issues a Bond, which as previously mentioned is an instrument of debt. The Federal Reserve purchases the bond from the Treasury. Yes, one federal governmental agency issues the debt (The Treasury Department) and another quasi-federal government entity (The Federal Reserve System) purchases the debt. The Federal Reserve System pays for the Bond with a Federal Reserve Note, which is an obligation (debt) of the Federal Reserve System. Keep in mind that both Treasury Bonds and Federal Reserve Notes are ultimately both obligations of the United States of America. Sometimes the Federal Reserve System doesn’t even bother to actually issue a Federal Reserve Note; through an accounting entry it simply credits the Treasury Department with the amount of money that would have been on the face of the Note. Yes, it is simply an accounting entry. Next, the Treasury Department deposits these Federal Reserve Notes into its checking account at a Federal Reserve Bank. It uses the money to write checks that can then pay expenses.
As you might expect, the process is a little more complicated than I have described: Federal Reserve Notes are backed by the assets of the twelve Federal Reserve Banks. Most of these assets, however, are United States Treasury Bonds, which have been purchased by commercial banks and deposited at the twelve Federal Reserve Banks. The commercial banks are required by law to take a certain percentage of their customer’s deposits out of their bank vaults and use this money to purchase U.S. Treasury Bonds. If a commercial bank is short on cash, it can go to the Fed for a short-term loan. Also, if a bank is in financial difficulty, the Fed will step in to stabilize its finances or find a bank that will purchase its assets, if possible. Customer’s deposits are insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC), which of course is another agency of the United States of America and is backed by its full faith and credit — meaning United States taxpayers.
If you look at the above scenario in aggregate, the government uses the banking system to greatly expand its ability to spend and, in fact, create money, which can be done at will. The down side is that all this newly created money carries the risk of inflation, and the debt, regardless who holds it, eventually has to be repaid with interest.
In the end, because there are no hard assets, like gold or silver, to back up the debt, if there is ever a default by our federal government, the whole system will collapse like a house of cards!
Back to Keynes
If you remember, an economic recession is evidenced by extraordinarily weak aggregate demand. As we know, government spending is a component of aggregate demand. So, according to Keynes a massive infusion of government spending into the economy will kick-start consumer spending, and thanks to the multiplier effect will circulate throughout the economy, spurring production and increasing employment. This is intended to reduce government expenditures on unemployment insurance and welfare, and hopefully, more money will be paid in taxes increasing state and federal revenues.
But does it really work? It’s pretty obvious that “Full Employment” will never be 0%. Economists can’t even agree on its definition. According to a January 29, 2017 blog by the Economist, Janet Yellen (1946- ), a previous Federal Reserve Chair, believed that with an unemployment rate at 4.7% the U.S. was close to maximum employment. In other words, if the unemployment rate were to go much lower the Fed should raise interest rates to effectively “cool down” the economy. However, according to the same blog, only 69% of American adults have a job. And in many states, laid-off workers are only on the unemployment rolls for five months; afterwards, they are no longer counted in unemployment statistics — whether or not they have found work.
Since 1948, the lowest official unemployment rate enjoyed by the U.S. economy was back in May of 1953 with a rate of 2.5%. The highest was 10.8% back in 1982, during Ronald Reagan’s (1911–2004) first term in office and Paul Volcker’s (1927- ) first term as Federal Reserve Chairman.
With only a few exceptions, the U.S. has been operating a budget deficit every year since the 1930’s. Meanwhile, our federal debt has gone from about $257 billion (about $2.34 trillion in today’s dollars) in 1950 to $20 trillion today. So much for deficit spending paying for itself. In the meantime, recessions have come and gone in accordance with general business cycles, just as they have throughout history. In fact, as we discovered earlier in the chapter, there is no way to prove that government stimulus has had any significant impact on long-term national unemployment.
The first problem with Keynes is that stimulus spending has historically been project oriented. The federal dollars certainly help the companies (and their employees) contracted to repair roads and bridges, and build buildings. And, there is also a positive effect on the communities where the work is being done, however, the benefits are primarily localized and scattered unevenly around the country (The most powerful members of Congress typically make sure that their districts get the bulk of the money.) We should keep in mind, however, that if the projects were needed anyway, then it wasn’t stimulus spending; it was simply the federal government freeing up funds that it needed to spend anyway. It is worthy of mention that in cases where these projects add more value to society than their cost, the money is well spent; however, the value is not in stimulus but in the intrinsic value of the projects.
The second problem is that the multiplier effect is limited. I previously gave the example of my imaginary computer purchase. Let’s hypothetically multiply that by 50,000 purchases all made by taxpayers who received stimulus checks. All of the stores that benefited from this boondoggle increased their sales and profits, but only temporarily. So maybe for a few months their stores were a little busier than normal and maybe they added some temporary employees — but once the stimulus money was gone, their businesses went back to previous levels. The effects going up the supply chain were also temporary. Factories receiving more orders may have temporarily increased production, added a third shift and hired some employees, but only after first reducing inventory levels. Smart companies would not have made major investment decisions in new factories, equipment or human resources — based on a short-term increase in orders. In addition, their production facilities may be in Mexico or China, not the United States. In other words, the government stimulus did little more than create a temporary bubble in the economy. Because it was temporary, it simply confused the natural economy, making business decisions more difficult.
The third problem is inflation. We know that the holder of a treasury bond assumes a risk that the issuing nation will never repay its debt and the bond holder will be stuck holding a worthless piece of paper. But who is at risk with inflation? Holders of the inflationary currency; in our case U.S. dollars and dollar-based assets. Why? Because every year those dollars are worth less, and consequently the purchasing power of the dollar is less, meaning that products and services cost more, reducing our standard of living. Not everyone is lucky enough to have their earnings adjusted for inflation.
In the 1950’s, the average house cost about $17,000, a gallon of gas cost 20 cents and you could purchase a full-size car for under $1,800. Overall, the purchasing power of a dollar in 1951 is equivalent to about $10 today. In other words, just in my lifetime, the dollar has lost 90% of its value!
The fourth problem is that inflation confuses the market. There is always a lag between the actual reduction in the currency’s value and the market’s ability to make proper price adjustments. With high inflation, companies have a very difficult time assessing true market demand, setting wages, making purchasing decisions, properly valuing inventory, and knowing what future interest rates will be charged by banks — all of which makes accurate business planning difficult. And finally, remember that inflationary government spending was supposed to reduce unemployment; however, we learned in the 1970’s that the strategy does not necessarily work. In fact, inflation actually worsens the unemployment problem. Because of high prices people spend less, which cause companies to lose sales, lower capital investment, and reduce employment levels.
The fifth problem is related to the idea that money is wealth. Money is simply the instrument or medium of exchange. True wealth, as explained by Adam Smith, is represented by the goods and services that money can purchase. Therefore, a nation is not wealthier because it prints more money. So, whether inflation occurs or not, the decision by governments to spend money, simply to stimulate the economy — by filling a perceived gap in aggregate demand — is inherently foolish. The problem is value. Every dime that the government spends should add more value to society than it costs the taxpayer, and every dime should be in accordance with good governance. As a base of comparison, let’s look at a private-sector company. The goal should be to provide the customer with a product or service that is priced less than its value to the customer. This value could be intrinsic to the product; or the value could be derived from its convenience, or from providing the customer with outstanding service. But in any case, the value is not determined by the company but by the customer. Therefore, to maximize value to the customer and profit to the company, every employee must provide more value to his or her employer than they are paid in wages. Every business expense and every investment must return more value to the company than its cost. The same should be true with government spending. Every dime that the government spends should add more value to society than its cost to taxpayers.
The sixth problem is to blame insufficient aggregate demand as the source of unemployment. History has proven over and over that consumers have an unlimited desire for products and services. This demand is only constrained by purchasing power, which is a function of three factors: personal debt, savings and personal income. Personal debt is limited by the lendable value of your assets, like your home and automobile, and your ability to borrow unsecured funds based on your income and credit history. So, once the lendable equity in your home is used up and your credit cards are maxed out, you have hit a wall and your spending is limited to savings and personal income alone. Also, your net income (purchasing power) is reduced by the monthly payments on your debt.
Public sector jobs are necessary and desirable, but only to the extent that they provide more in value to society than their cost. In my opinion there should be a huge demand for valuable, tax supported jobs in the future, primarily in health care, education, energy and the rebuilding of our aging infrastructure.
Let’s take another look at the multiplier effect, only this time we’ll spend $1 trillion on infrastructure. We will still have the temporary benefit of stimulated employment, primarily in construction related fields. However, once the projects are finished there will still be long term benefits to society: A new bridge, for example will last for decades. The water supply in Flint, Michigan was recently worse than many third world countries and Flint is just the tip of the iceberg, as many cities around the country are in desperate need of new water and sewer lines. New and improved levees around the country would prevent much of the devastation caused by flooding. New high speed, high tech rail system would not only be safer but provide a much more efficient mode of transportation in and between major cities. Rush hour traffic in Los Angeles, Chicago and New York all show the gross inadequacy of our transportation systems. Also, our airports are old, overcrowded, and inefficient.
In addition, there is a tremendous need to transform our energy infrastructure away from coal and gas. And finally, there are huge unmet healthcare needs in this country that cannot be met under our current convoluted and overpriced health care system. In 2013, U.S. government spending on health care was $5,960 per capita (per person), which was the highest of any country in the world, including those with universal health care coverage. Yet even with Obamacare we still have 10% of the population, about 28 million people, not covered by health insurance!