Lecture 5. DEFICITS & THE DEBT RATIO (DR)

Inflation
In a free market, commodity prices seek a point of 
equilibrium. But population growth and improving standards 
of living continually induce buying, scarcity, and an 
increase in the general level of prices: inflation. 

Inflation causes money to continually lose purchasing power
and encourages spending or investment rather than saving.

High inflation rates generally occur with a scarcity of 
goods or, said otherwise, an excess of money. Thus, the 
need to closely monitor inflation when employment rates are
high or with high levels of production or investment. The 
Fed counterattacks inflation by raising interest rates and
and otherwise reducing the money supply.

Inflation is complicated by domestic shortages, e.g., oil.
Then, competition for goods is world-wide and can occur
during low domestic employment rates. This may cause 
"stagflation": unemployment plus inflation.

Inflation lowers the real interest rate (the nominal rate
minus inflation), which effectively lowers the cost of 
borrowing. The threat of inflation is a spur to investment.

Inflation also helps the debtors by eroding the real value
of their debt. Lower real interest rates means faster
growth and lower unemployment, boosting job and wage growth.

For those living off of capital rather than wages, 
inflation erodes their assets and capital. So investors are
not in favor of lower real interest rates, faster growth, 
and lower unemployment. They like a "strong" dollar and are
opposed to "loose" money policy.

The Federal Reserve targets 2% inflation as a beneficial 
goal because it induces high-return investments rather than 
low-return savings. It also allows for some prime rate 
reduction during a recession. Above all, it avoids 
deflation.
Deflation
Deflation is the end result of a declining money supply in 
the hands of consumers. The consumers simply lack cash. 
Deflation causes money to continually gain purchasing power
and induces saving rather than investment. Who would spend 
a dollar today if it could buy more tomorrow?

The Federal Reserve can control inflation by removing money
from circulation by methods described in Lecture 4. 
Control of deflation is an entirely different matter. Money
must be inserted into the economy to promote spending, but
it requires enough political will to overcome the 
opposition of deficit hawks.

During the Great Depression, the political will was 
insufficient until an Austrian economist, Adolf Hitler, 
showed us how to insert money into the economy. He ended 
the Great Depression where all others had failed.
Deficits & Debt
Historically, inflation is almost permanent. The Great 
Depression was a rare period of deflation. The Federal 
Reserve targets 2% inflation to avoid deflation like the 
plague. But to assure inflation, while we are a net 
importing nation, the money supply must continually
increase and the government must almost always have a 
deficit.

Proof? Suppose now that we want the government to have
a surplus consistently.  Using our accounting model,
we would have:

Tax revenue - Government Spending > 0 (consistently)

or T - G > 0 and therefore

(1) T - G = (I - S) + (X - M) > 0

Because the trade balance has been and will be 
negative for a long period,

Exports < Imports or X < M 

so we can transpose (X - M) in equation (1), yielding:

 (I - S) > (M - X) > 0

since M > X.

Therefore, (I - S) > 0 or more simply:

 I > S

or Investments > Savings 

With Investments being low during a recession, Savings
are even less.  Thus a continual budget surplus dooms
the private sector to be a consistent net borrower.
And since most of the wealth and income is held by
millionaires and billionaires, the average consumer
will be very reluctant to consume.  

Therefore, government spending (which inserts money
into the economy) must generally be greater than tax
revenue (which removes money from the economy):an
almost permanent budget deficit.
                 
Thus, a budget surplus is rare and occurs only when tax rates
are high during a prosperity. Indeed, we have had only one
true budget surplus in the last 40 years. And that was due
to decreased military spending during a technology boom
with a higher tax rate than now.

The result of the Clinton budget surplus or low deficits was
the removal of money from the private sector, a fiscal drag
which led to a recession early in the first Bush
administration.   

With near-permanent inflation, a growing economy must 
continually have (minor) budget deficits and the ND must 
almost continually rise. With Congress's need to tax 
or borrow whatever it spends, it is mathematically 
impossible to consistently lower the ND. A permanently 
balanced budget is the fetish of ignorant fools and must be 
avoided like the plague. As we will show below, the ND can 
only be judged relative to the GDP and to the money supply. 

In fact, permanent deficits are sustainable if, over the
long-term, the additional tax revenue provided by GDP 
growth exceeds the added bond interest payment on the annual 
budget deficit. This can be assured by adequate tax rates
and a full employment policy to assure both high tax 
revenues and low bond interest rates.

Think of government as a corporation which starts its 
growth by issuing bonds. As the corporation succeeds and 
grows, it issues more bonds. Its outstanding debt rises 
continually and everybody is quite happy - as long as 
dividends are adequate! 
Debt Ratio (DR)
While the ND has no direct effect upon GDP, another 
important measure of our economic health is our national 
indebtedness, the DR, the ratio or percentage of the ND 
relative to the GDP:

(1) DR = ND ÷ GDP

Statements about the annual budget deficit or the ND become
more meaningful when compared to the GDP.

Essentially, the ND is an accumulation of debt over the
last 80 years. The GDP is an accumulation of retail sales
over a 12-month period. So, actually, the DR is not
really a pure, dimensionless ratio. The dimension of the
numerator is in dollars but the dimension of the
denominator is in dollars per year. Therefore, the
dimension of DR is in years.

How should we interpret the DR in terms of years? If, 
starting January 1, all the retail income of the nation 
were used immediately to buy Treasury bonds and notes, a DR
equal to 50% would mean that the entire ND could be 
completely paid off in six months. A DR equal to 200% (like
Japan today) would mean that the ND could be completely 
paid off in two years. Our DR (about 98%) would mean that 
our ND could be completely paid off by Christmas.

Of course, this is nonsense. In fact, the ND is never "paid
off", is rarely reduced, and is  indirectly related to the 
GDP only by tax revenue and debt interest expense. The ND
is financed by paying interest on Treasury bonds and notes.
The only criterion upon  which to judge the present and
future direction of our annual budget is the long-run
sustainability of annual interest payments on the ND.

A more pertinent ratio would be the ND relative to "base 
money", or M0, the total sum of money issued by the 
Treasury. M0 includes currency and bank reserves. It does 
not include less liquid funds, such as CDs. That ratio 
(ND/M0) would estimate how much the money supply is 
encumbered.

The value of the DR is not as important as the rise or
decline of the ratio. The economy is headed in the right
direction when, over time, the ratio is being reduced,
no matter how slight the reduction. The thesis of this
course is that the fiscal policy of the federal government
should be full employment (consistent with low inflation)
through incremental reduction of the ratios by means of
stimulated GDP growth. 

Substituting from equation (5) of Lecture 1 for GDP into 
equation (1) yields:

(2) DR = ND / GDP

       = ND / [(Productivity)
              × (Total Annual Available Work Hours)
              × (Employment Rate)]

The analysis of the denominator in Lecture 1 showed 
that, in the near-term, the DR is dependent entirely upon 
both the ND and stimulus. Unfortunately, these two factors 
work against each other. A stimulus will increase both the 
numerator and the denominator. The DR will then either rise
or fall, depending upon the efficacy of the stimulus. This
dilemma is the central question of Keynesian and Lernerian
theory and will be analyzed in other lectures.
Safe Upper Limit for the Debt Ratio
According to the deficit hawks, our DR is now beyond its 
safe upper limit.   But what is the safe upper limit?

Concerned about the Treasury bond market, Federal Reserve 
Chairman Alan Greenspan favored Bush’s 2001 tax cut 
because he found the DR too low at 56%. At that time, Rep. 
Paul Ryan (R-Wisc) concurred. Speaking of the ND, Ryan 
said, “It's too small."

On the other hand, the European Central Bank (ECB) requires
that member nations maintain a DR less than 60%.
Apparently, the only good DR is 58% ± 2%, which is
ludicrous.   Obviously, the ideal DR is above“too low”.
But what is “too high”?

In fact, as we explained above, the DR is too high only 
when Treasury bond “vigilantes“ are able to obtain
interest rates that are unsustainably high. Using 
current data, our DR is 98.0%. Is that too high? Not yet, 
since bond interest rates remain near historic lows.

The DRs of Germany, France, and Canada are about 80%. 
Japan’s DR is over 200%. These nations are recovering
from recession but are generally prosperous.   The 
British Empire thrived for 200 years with DR values above 
1,000! Apparently, bond holders look beyond the DR and go 
for the best bet they can find. US Treasury bonds are still
the safest bet. Above all, GDP growth trumps the DR 
when it lowers the DR.

In fact, there is no critical value for the DR. Our best
monitor for economic health is the employment rate or rate
of production relative to peak production. If our economy 
is going at full speed and tax revenues are at maximum and 
the DR is declining, the market will buy Treasury bonds at
a low interest rate.

The DR can be controlled by measures that maintain full 
employment. The economy is almost always headed in the 
right direction whenever the DR is reduced, no matter how
slight the reduction.
Proceed to: Lecture 6.
THE TRUE LIMIT TO DEFICIT SPENDING
Thanks for your interest.
  Marvin Sussman, retired engineer

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