Thursday, February 12, 2009

Change We Can Believe In

Draw your own conclusions.

When the federal government spends money it hasn't taxed away from households, it must borrow the money by selling Treasury bills and bonds. Who buys those bills and bonds (i.e., who is lending the Treasury money)? Three broad categories of lenders exhaust the possibilities:

(1) Americans (which includes the Fed)
(2) Foreigners
(3) Other U.S. government agencies (e.g., the Social Security Administration); the Fed is not a federal agency; technically, it is a closely-held private corporation owned by member banks.

When repayment on the Treasury bills and bonds is due, the U.S. Treasury must pay back the principal plus interest. Is it a good idea to finance federal spending this way? To understand the technical details of that question, one really needs to study a bit of economics and finance (for many, that would be something like torture, so let's not do that here).

Instead, let's consider a different sort of question. Who benefits and who bears costs when we finance federal spending this way. Only the federal government gets to do this; states are allowed to borrow only for explicit capital projects.

When Americans are doing the lending, federal borrowing means "we owe the debt to ourselves." Since it is "ourselves" who will both pay the debt and receive the payment plus interest, the only real issue is which part of "ourselves" ends up receiving the benefit and which part of "ourselves" ends up paying higher taxes in the future than they otherwise would have. Careful research might ferret out an answer, but when Americans buy federal Treasuries, what we get is a transfer of tax liability within America, among Americans.

When foreigners are doing the lending (Japan has been the largest foreign buyer of U.S. Treasuries in the past) we get to use the savings of foreigners for a while. It's clear that foreigners benefit from interest paid and that Americans pay the costs of higher taxes in this case.

If the money borrowed generates greater American benefit than the value of the interest paid, we Americans get a good deal, and so do the foreign lenders. Lots of folks might agree that building bridges, roads, and other long-lived capital projects with foreign-borrowed money makes sense. Even financing a higher level of American education---thereby building human capital---probably make sense. But does foreign borrowing to finance American Social Security payments make sense? You decide.

When other U.S. agencies finance federal debt, it's pretty much moving the money from the hip pocket to the front pocket of government. Except for the interest paid. The interest payment has to come from somewhere. Guess where it comes from. That's right, future tax payers get to pay higher taxes than they otherwise would have, to cover the interest due.

Is that a good idea? It might be if future tax payers enjoy benefits equivalent to the interest paid. Whether they will or not depends on what the borrowed money goes to finance in the present day. Again, long-lived capital projects---building physical or human capital---might make sense, if the capital projects yield benefits for future generations.

When the Fed buys the U.S. Treasuries, it does so by creating new money. Who benefits and who bears costs from that? The plot thickens.

First, the Fed itself benefits, because it earns interest to finance its annual operations. That includes agreeable salaries and digs for Fed officials and employees. The Fed takes what it decides is agreeable enough from this pool of interest payments and remits the rest back to the Treasury. So, the Fed and the Treasury clearly benefit. They get to command real goods and services with money just created out of nothing. That's truly a "free lunch" to the Fed and the U.S. Treasury. But basic economics assures us there is no such thing as a free lunch. So who bears the cost of this particular lunch? See if you can guess.

If the quantity of real goods and services available to be bought is fixed, the new money created by the Fed causes some of those real goods and services to go to the Fed and the Treasury instead of going to the private sector---households and businesses. If that happens, Americans have paid for the Fed's and the Treasury's free lunch by not getting to use the real goods and services themselves. Just which Americans paid for the lunch depends on issues far too complex to sort out here. It could be you and me, though.

If the expenditure of the new money spent by the Fed and the Treasury somehow causes additional real goods and services to be produced, which otherwise would not have been produced---then Americans enjoy greater income than they otherwise would have. The dollar value of production is equal to the dollar value of income during a year. That's a good thing, but does that happen? Again, that depends on way too much to sort out here.

A second category of beneficiaries of the Fed's buying of U.S. Treasuries is owners of banks and other non-bank financial institutions (like insurance companies, hedge funds, and finance companies). Banks taken together are able to increase the amount of new money injected by the Fed by a multiple of about 10. Technical details of how this works are part of the torture we agreed not to inflict. Banks don't have to make new loans, but they usually want to, since banks earn interest income for their shareholders by making new loans.

Just now, because so many loans made in the past have turned out to be really stinky loans (e.g., toxic assets), banks are not as eager as they usually are to create new money using the high-powered money the Fed has made available. That's the so-called "credit crunch." Slower credit right now might be a good thing. Depends on what borrowers do with the money, doesn't it?

Finally, we get to a sort of bottom line. If new money created by the Fed and the banking system do not increase production of real goods and services beyond what otherwise would have been produced, and if the new money is actually spent on available real goods and services, we get inflation. If the new money is just sucked up and held by the banking system or by households or businesses or foreigners, we don't get inflation. So which is it? Do we get inflation or don't we?

We're finally down to a nub of the whole stimulus spending issue. Will the Treasury's deficit spending just cause inflation, or will it cause greater production of real goods and services than otherwise would have been produced over the same accounting period (say the next two or three years). The correct answer to that question is "no one knows for sure." That includes BHO's economic advisers, all the other economists in the world, and all the media wags (especially the media wags).

That's not a satisfying answer, but it goes a long way toward explaining why federal deficit spending remains a political issue, and probably always will.

Now I will offer a humble observation. Since no one knows for sure whether federal deficit spending stimulates the economy, and since the beneficiaries and bearers of costs created by federal deficit spending are ambiguous at best, maybe we American citizens shouldn't allow the federal government to deficit spend on anything except bona fide capital projects---much like the states.

Politicians will definitely not like that idea; neither will banks and non-bank financial institutions. Now that you've read this, see if you can understand why they won't.

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