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Budget Surpluses Hurt the Economy

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My obsession for the past two years has been economics, when I was introduced to Modern Monetary Theory on a debate board.


What Is a Surplus, Anyway?

"Federal budget surplus" sure sounds good, doesn't it? Surplus. That means, all you need, plus some extra! Bonus! Let's do it!

Well, here's what happens when the federal government runs a surplus—they take in more dollars in taxes than they spend. That means the federal government has a pile of dollars to do with as they wish. But that also means that those dollars have been removed from our economy. Permanently. You and I now have less money to spend, and that's not good for consumer spending, which drives the economy forward.

What Can the Government Do With Their Surplus Dollars?

Well, they can spend them, but if they did that, it would be more government spending, and we would no longer have a surplus...

They can buy back government securities with those dollars, which would lower the "national debt" on paper. But people, banks, and businesses hold treasuries for a reason - they want a perfectly safe place to park their saved dollars, and they would just end up buying more treasuries (which would increase the "national debt"). So that doesn't get us anywhere... (Lowering the number of outstanding securities is just a book operation, anyway, as it doesn't improve the government's position one bit.)

They can save those surplus dollars - but the government does not save or earn interest, in any real sense of the word. They can't put that money into private banks— even if they could, that would just remove more dollars from the economy when the banks paid them interest...

Or, they can put those dollars in a virtual box and just sit on them, waiting to spend them later. So, let's say they save them for next year... but if, including those saved dollars from the year before, they spend more next year than they bring in with taxes, that would still be deficit spending. When the government runs a surplus, those surplus dollars can never re-enter the economy without deficit spending. This illustrates that deficit spending is the only way that net dollars can be introduced into the economy. It also illustrates that government surpluses remove dollars from the economy, permanently.

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So there is really nothing at all that the government can do with surplus dollars. They are virtually shredded, subtracted from the total of previously created dollars on the government's ledger. When the government decides they want to add more dollars into the economy, they must spend more than they take in, and new dollars are created at that time.

(In practice, the government does not store all of the dollars they collect. The dollars the government collects through taxes are electronic—with a few keystrokes, the Fed marks the reserve accounts of banks up or down to reflect the total of the checks they receive, and banks mark your account up or down to reflect your check. You don't even have the option of paying the IRS in cash.)

What Happens When Dollars Are Removed From the Economy?

Every dollar the government spends eventually ends up in the hands of people. Direct recipients of government spending include government employees, people on Social Security, welfare recipients, soldiers, etc. Somewhat less direct are the beneficiaries of Medicare and Medicaid payments, grant recipients, and the many businesses that supply and service the government. Cut government spending, and some or all of these people and businesses will suffer. Plus, there will be secondary effects, because consumer spending will go down, causing businesses to contract. More people will lose their jobs, and consumer spending will continue to fall, and the cycle continues. Some people expect that businesses will somehow pick up the slack, but in reality, businesses will be competing for fewer dollars, and somebody is going to lose that battle. Austerity never works.

Dollars are also removed from the economy by saving: specifically, when dollars are converted into government bonds. To illustrate, if everybody were to put away more money in the bank, that bank would now have more cash on hand: to a bank, these dollars are excess reserves. Banks don't like excess reserves, because banks only earn 0.25% interest in their reserve accounts at the Fed. So they either loan out those excess reserves at the interbank rate to other banks that need more reserves, or they buy government securities (which pay the same interest rate as interbank loans). A little interest is better than nothing. Anyway, you can see how saved dollars end up as t-bills. And since the pile of t-bills never gets any smaller, you can consider those saved dollars retired from normal use, in a net sense. You can always cash in your t-bills and spend the proceeds, but since more people are buying t-bills than cashing them in, in a net sense dollars are always being exchanged for bonds (i.e. the "national debt" keeps growing).

Deficit spending serves to replace those saved dollars so the economy does not contract, plus the addition of new dollars allows the economy to grow. Government spending also serves to distribute money to the lower end, where it is most needed.

What Would Happen Were We to "Pay Down" the National Debt by Repurchasing Bonds?

The "national debt" is actually savings, extra dollars that have been invested in (exchanged for) government bonds. People/banks/companies with saved dollars have chosen to buy those bonds, mostly because they are looking for a perfectly safe place to park those dollars. (There is actual demand for this safety, because even bank accounts carry a bit of risk, as they are only FDIC insured up to $250,000 per account.) Government bonds are, for all practical purposes, savings accounts. So "paying down" the national debt is done by exchanging dollars for government bonds. It is analogous to a bank removing money from your savings account and crediting your checking account (or simply handing you the cash). Neither party is in a different financial position than before. The government has created, say, $1 trillion in new dollars, and they have destroyed the same $1 trillion in bonds.

The upshot? The people/banks/companies that once voluntarily held bonds are now holding dollars. When this exchange is forced upon banks (as happens in quantitative easing), the banks' usual response is to turn around and repurchase more government securities. Logic tells us that since safe, low-interest government bonds were the investment of choice before, they will be again. If that option is not available, they will be shopping for the safest investments possible. If those people had wanted their money in any other investment, they presumably would have already done so.

Have We Ever Tried to Pay Down the National Debt by Running Surpluses?

Yes. There have been six times in America's history where we have tried to pay down the national debt by running budget surpluses. All six attempts were followed by depressions. Frederick C. Thayer has a nice website on the subject here.

© 2012 John

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