Tuesday, January 25, 2011

The Federal Budget is Not Like Your Budget

Once upon a time, the budget of the U.S. government was just like your budget or any other household budget.  This was because at one time the government was on a gold standard.  Each dollar could be exchanged at anytime for either a small bit of gold, silver, or some combination of both.  The amount of goldsilver that you could get with a dollar would change every so often until it was changed for the last time when the United States entered the Bretton Woods system which set the value of the American dollar at 35$ per gold ounce.  Then, 27 years later, in 1971 on the Ides of August, Richard Milhouse Nixon sunk the third proverbial knife into the Gold Standard by announcing the end of gold convertibility of the U.S. dollar(West Germany and Switzerland were first and second to exit the Bretton Woods system).  The U.S. budget was no longer like a household budget.

So what do I mean when I say household budget?  A typical household or business must either earn or borrow money before it can spend it.  Everyone knows this:  You can't spend 5$ until somebody else gives you 5$.  In other words your spending is "revenue constrained".  When the U.S. had to convert dollars to gold, it was revenue constrained because it had a limited amount of gold.  Since 1971 the federal government no longer has to convert dollars to gold.  Combine that fact with the fact that the federal government, and only the federal government, can create dollars and you'll realize that the federal government is no longer revenue constrained.

This last point bears repeating.  The U.S. government doesn't have to tax or borrow money to spend it.  Most of us learn in our civic class that the government taxes it's citizen and then spends it on roads and tanks and other items.  If the government needs more tanks or roads, it must raise taxes.  However, this is no longer the case for the federal government.  To buy the extra tanks or rail, the government can create money *poof* out of thin air to buy whatever it wants.  It could just create new money all day every day until the end of time and it would never run out or have to borrow or collect taxes.

From what I've seen, the first reaction most people have to this statement of fact is, "Inflation!  Inflation! Inflation! What about Inflation?" which just proves the point.  I think most people realize that the government isn't revenue constrained because nobody ever seems to say, "That's not true, the government can't spend whatever it wants!  It'll run out of dollars.", they just object to the obvious consequence of a government spending way more than it makes in taxes: inflation.  So let's put these these two statement of facts together.  If government spending isn't revenue constrained, but can cause inflation when it spends a lot, then government spending is constrained by inflation, not revenue.

Why is this significant?  Because if federal spending is constrained by inflation and not tax receipts, then it completely changes when the government can "afford" something.  If inflation is low or negative, then the federal government can spend more money or cut taxes. If inflation is high, then the federal government can't afford any more tax cuts or spending.  In fact, that means the government should spend less andor raise taxes.  These last two statements hold true no matter how high or low the current budget deficitsurplus is.  This means that if inflation is negative, the government can "afford" to cut taxes and increase spending even if it's already in debt.  It also means that if inflation is high, the government needs to increase taxes and decrease spending even if it has a budget surplus.

As you can see, this is not like your budget at all.  Where your budget requires you to make every dollar you spend, the federal government's budget does not require this.  The fact that government spending is constrained by inflation and not revenue is one of the central facts that Modern Money Theory is built on.

All I've said in this post is that government spending is constrained by inflation, not revenue.  What I did not say is that the government can  or should spend all willy-nilly without consequence.  There is a consequence and it is inflation.  What I am saying is that when congress decides if it can "afford" to do something, it shouldn't make that determination based on what the current budget deficitsurplus is, it should make that decision based on how high inflation is.  Unfortunately, the people running our country either don't realize this or act like they don't realize this.
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