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When Should We Start Worrying About Deficit Spending?

Since President Biden took office, he has presided over a massive stimulus spending bill, proposed a multi-trillion-dollar infrastructure plan and large investments into education, and recently issued an executive order raising federal contractor wages to a minimum of $15 per hour.

Whether you color yourself red, blue, or purple, all this proposed spending may have you asking, where is the money coming from and what are the consequences of so much federal spending?

The idea that the US government can go on spending simply doesn’t compute to anyone who operates a household budget. We know that when there is a limited number of dollars, you must make tough choices or face going into debt. If we apply that thinking to our country, it raises concerns that future growth will be weighed down by higher taxes and that government benefits will be reduced or eliminated.

Stephanie Kelton, an economist, professor, and author of The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy, says that thinking about the US government’s budget the way we do our own is one of several myths that make it harder to understand the way deficit spending works and its impact on the economy. By explaining Modern Monetary Theory (MMT), she offers a different way to look at deficit spending, and although it certainly is not a view shared by everyone, President Biden has signaled that he is considering MMT in his policy decisions.

A good place to start with MMT is understanding how the US is fundamentally different than its citizens, corporations, and states. As anyone who runs a household, company or local government budget knows, when you want to increase spending, you need to find a corresponding increase in income or reduction in other spending to avoid going into debt. We must ask ourselves “where is the money going to come from?” According to Kelton, that is the right way to think about it for anyone who uses money but cannot print it. The trouble is, we often apply this same logic to the federal budget despite our government’s ability to print money.

MMT points out that the US is not just a currency user; it is a currency issuer and one with monetary sovereignty. To have monetary sovereignty a country must issue its own currency, avoid tying the value of that currency to a limited resource (like gold) and only borrow money in its own currency. Having monetary sovereignty makes it virtually impossible to go broke because the country can print new money to fund expenses and pay off debts it may incur. Unlike most of us who can’t print new dollars to pay off our credit card balances, the US and a few other countries can.

It is important to say at this point that MMT is not an endorsement of unlimited deficit spending paid for by printing money, though its critics like to suggest that MMT stands for magic money tree. MMT simply states that running out of money is not a real consequence for a country with monetary sovereignty, and rather than worrying about how deficits are going to cause our country to go broke we should look at the real consequences of deficit spending, both good and bad.

In MMT, deficits are not inherently bad and are not, in and of themselves, a sign of overspending. The way MMT economists measure if the government is overspending is to carefully monitor inflation.

When the government spends, it is putting money into the hands of currency users. There are many ways to do that, such as stimulus payments, tax cuts or federal programs, but no matter the method, the risk is the same. When there is a greater supply of money available in currency users’ hands, more people compete for the same goods and services and the resulting scarcity could cause prices to rapidly increase. This has happened in other countries that have printed endless amounts of money without regard for inflation, which ultimately diminished the value of their currencies and sent prices soaring.

Of course, for inflation to occur, you have to reach a point where resources become scarce. Up to that point, additional money in the hands of currency users is simply more money to spend on available resources which is a good thing for economic growth.

How do we know if the government still has room to spend without causing inflation? Believers in MMT use models to measure things like how many people are unemployed (overall or in specific industries) and how much unused capacity there is for companies to increase output. The focus is on how many real resources, like raw goods or even people to work, companies have available to maximize their output. Only when we reach the point of fully utilizing our real resources would we expect to see the kind of scarcity that causes inflation.

This is very different than how the Fed has managed inflation for the last few decades. The Fed has maintained a policy of targeting around 5% unemployment, meaning that they consider us being at maximum capacity and at higher risk of inflation when millions of people are unemployed. Looking at this policy from an MMT viewpoint, 5% unemployment means there is still excess capacity available, and inflation is not yet imminent. If that is true, the government could have been putting more dollars into the hands of currency users without causing excessive inflation and the failure to do so represents a lost opportunity for growth. It also represents a lost opportunity to use deficit spending to address challenges like healthcare, education, and infrastructure in ways that could materially improve people’s lives merely to avoid a risk of excessive inflation that has not materialized in decades.

While we often think of deficits as a burden being laid at the feet of future generations, MMT argues that periods of high deficits have correlated to subsequent increases in wealth and incomes for future generations. For example, the period after World War II represented a major growth period in our economy despite the high deficits that were incurred during the War. Kelton attributes that to the fact that during WWII, the government focused on maximizing resources and output to make things like planes and guns and food, irrespective of the deficit (just as MMT would have us do now).

More recently, government stimulus helped the country (slowly) recover from the depths of the Great Recession such that unemployment fell to historically low levels without causing inflation. Many economists including Kelton believe that had the US done more deficit spending following the Great Recession, the recovery would have been even faster and more effective. This is likely an influence on the current administration who has opted for larger government spending in hopes of accelerating the recovery.

At its essence, MMT is about developing policies that will increase output or improve lives by maximizing real resources, without an undue focus on the deficit the policy creates. If the policy is thought to be highly beneficial, deficits will be tolerated as will a sustainable amount of inflation. If the policy is expected to cause excess inflation, it would need to be modified or paired with policies that would simultaneously take money out of the economy to stave off price increases and bottlenecks in productivity.

Modern Monetary Theory is controversial and far too complex to fully explain here, but it does provide a framework to understand why the government is pursuing policies that beget huge deficits. If we can take anything from MMT, it is that inflation remains a key metric to assess the health of the economy even in an environment where deficits are embraced.

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