Wednesday, July 15, 2009

I like Bob McTeer, but he has this one wrong!

I like former Dallas Fed President Bob McTeer and have always considered him an economist who was "in-paradigm," however, I have to admit that the recent posts on his blog have me worried about where he stands. Take a look at this one:

"A substantial increase in the personal saving rate was announced last Friday to much fanfare. I hate to be a killjoy, but it was all an illusion.

The national saving rate is composed of the personal saving rate, the business saving rate, and the government saving rate. The personal saving rate is disposable income minus consumption; government saving is equal to its budget surplus. A budget deficit represents negative saving by the government.

What happened in May was that the government increased its budget deficit (increased negative saving), borrowed the money, and paid it to individuals as part of the stimulus package. Since individuals saved less than 100 percent of their higher income, they added less to saving than the government subtracted from it..."

Let's go with that last paragraph where he says, "What happened in May was that the government borrowed money and paid it to individuals..."

Assume for a second that the sequence that he lays out is correct--that the government must first go out and borrow money and then use that money for spending.

Of course we know that this is not correct for we are not on a gold standard or fixed exchange rate and we also know that the government is spending all the time and it spends first, by crediting bank accounts electronically, then sells securities later only to manage the level of reserves in the system. That sustains a desired interest rate. The sale of securities, therefore, is not borrowing per se. (McTeer knows this.)

As far as tax collection is concerned, it functions to impart value to the currency and to manage the level of aggregate demand. Moreover, since we pay taxes in the government's own money (coin, cash or bank reserves), that money must first be spent into existence by the government before we can even pay the taxes. (Think of it like in the game of Monopoly, when we pay tax after landing on "Community Chest" we are merely giving back some of the money that has already distributed by the game.)

However, let's assume for the sake of argument that McTeer is correct when he says the government must first go out and borrow money from someone in order to spend it.

A simple balance sheet analysis shows how Mr. McTeer's analysis is very misleading.

Assume the government has assets of zero and liabilities of zero and assume the public has assets of $1,000 in cash and liabilities are zero (net worth of $1000 or to balance out the right side of the balance sheet, liabilites plus net worth). National net worth (gov't plus the public) is $1,000.

Let's assume now, that the government needs $500 for a stimulus package, so it sells a bond in the amount of $500 to "raise the money."

The private sector parts with $500 in cash to buy the bond. The reserve account of the bank where the public had its money is debited $500 and the government's account at the Fed is credited $500. The government now has an asset of $500 and a liability of $500 (the bond). Its net worth did not change.

The public now has $500 less cash, but it has a bond in the amount of $500, which is an asset, so the public's net worth has not changed either, its asset mixed has just changed. National net worth is still $1,000. (I am leaving out the payment of interest for the sake of simplicity.)

Now watch what happens when the government spends the money. Let's say it spends the $500 on a tax rebate or unemployment insurance payments or infrastructure investment or spending for college tuition or all of the above.

When the government makes that payment, private sector reserve balances are credited $500 and the government's account at the Fed is debited $500. The government once again has a cash balance of zero, but not zero assets. That's because you need to count the new infrastructure or added output of the workers that the government paid or the higher education level of the citizenry because those are all part of the assets of the government and the assets of the nation. These things may be somewhat harder to value because they are often intangible, but let's assume they should be worth at least as much as what the government paid for them. So for the sake of simplicity we can say that the government now has a liability of $500 (the bond) and assets worth at least as much as the $500 in investments it just made. Therefore, we can say that the government still has zero net worth (assets equal to liabilities).

On the other hand, the public's bank account now has its original $500 in cash, a new reserve credit of $500 (that the gov't just spent) and a bond in the amount of $500, which is an asset. The public's net worth has just gone to $1500 from $1,000 and so did the nation's net worth (gov't plus public).

McTeer says that the savings rate is an illusion because the government ran a "negative savings rate" in order for the public to have an increase in savings. However, that is always true by definition. Only the government can be the net provider of savings to the private sector. On the other hand if McTeer wants the government to "save" it has to take in more than it spends, which again, by definition, reduces the savings of the private sector because government must either collect more in taxes than it recycles back, or provide less in spending, which equates to less aggregate demand, lower economic output, lower incomes, reduced wealth, less savings of the public, etc.

Another way to state this is, if the government runs a savings surplus, then the private sector has to run a savings deficit. Does Bob McTeer really think this is better?

McTeer's analysis also ignores the fact that the government actually gets something for its money and, therefore, doesn't really end up with a zero or negative net worth. As I pointed out earlier, the government's spending on such things as education, health care and even unemployment insurance is an asset, even though they are often not looked at that way. A healthy and educated citizenry and a stable society are all part of the assets and capital of a nation, just like modern infrastructure or a strong national defense.

It would seem to me that sustaining output and employment or simply, "promoting the general welfare" (as it says in the Preamble to the Constitution), is as much an asset to the government and the nation as a whole, as having a strong military or roads and bridges over which commerce can flow.

What we musn't forget is that the government exists for the public purpsose; it is not a profit seeking enterprise, and therefore must be evaluated on how it fulfills that public purpose. (How peaceful, prosperous, just and egalitarian is our society?)

McTeer goes on to say that...

"A decline in national saving will necessarily be matched by a decline in national investment if it isn't made up by more saving imported from abroad."

But again he seems to misunderstand that savings are no more "imported" from abroad than they are imported from the U.S. domestic household and business sectors. (By the same reasoning I just used.) Government is the net supplier of savings, not just to the U.S. domestic sector, but in large part to the foreign sector, too. That's because, to the extent that deficit spending adds to U.S. aggregate demand, output, employment and incomes, we are wealthier (by the above example) and are able to consume more from abroad and this is what provides at least some of the foreign sector's savings. WE fund their savings, not the other way around.

On the other hand the U.S. could run budget and trade surpluses just like if we were on a gold standard, but that would reduce our standard of living vis-a-vis the rest of the world--by definition. This is probably why, over the past 220 years, there have been scant few times when we did this. And it's why the United States sits on top of the world when it comes to prosperity and economic output. However, if we listen to misguided views of how things work, this may soon come to an end.

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