We Have a Deficit of Logic

February 20th, 2015
in Op Ed

Written by Lawrence J. Kramer

In a recent article, Steve Hansen wrote about our economic woes:

"If tax relief were the answer, the economy should have ignited under Bush's tax relief in 2001 and 2003."

The idea of "the answer" takes us in the wrong direction. We need answers, plural. I believe that one of those answers is tax relief, but not tax relief of the kind that gets reversed when the other party takes power. We need something more durable, something with a powerful conceptual core.

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Follow up:

Ricardian Equivalence

Ricardian equivalence will thwart fiscal stimulus of any sort, including tax cuts, if we make a balanced budget the holy grail of fiscal policy. Only a populace comfortable with what would be called a fiscal deficit under today's accounting will respond to lower taxes by actually spending more money.

Suppose Congress enacted a law doubling Social Security at age 85. The benefit would be paid by printing money, i.e., by bonds bought back by the Fed. Leaving aside Ricardian equivalence for a moment, there is a pretty strong chance that such a benefit would cause people to reduce their nest-eggs: private pensions and insurance annuities would arise that "integrated" with the new benefit, providing a net level benefit at a lower private cost. Wages would rise, savings would decline - we have plenty of investment capital - and spending would soar.

We Don't Like Deficits

Why don't we do this? Because it would cause a deficit, and we don't like deficits. We have it in our heads that deficits must be closed, so deficit spending on a new entitlement would give rise to Ricardian equivalence, defeating the purpose of the benefit. But what is this deficit? What would we have less of? What would we run out of? We are awash in excess capacity, and the world wants to sell us more, and will STILL want to sell us more even if we run a perpetual deficit within reasonable limits.


We need only make the logical leap from outputs discarded to outputs not created.


No one would have less of anything if we ran a perpetual deficit. We'd just make and do more things for each other with the extra money we got. I know it looks like something for nothing, but, if you can use someone else's trash, aren't you getting something for nothing? We need only make the logical leap from outputs discarded to outputs not created. If the unproduced outputs would have a low marginal cost, then causing them to be produced and enjoyed would be tantamount to getting something for nothing. Not found money, exactly, but found stuff.

The Opportunity of Excess Capacity

So how do we get there from here? Let's start by assuming that the government simply commandeers what it needs. The idea is not so bizarre. Students of the French Revolution will remember corvée labor, a system under which men were forced to work for the state as a form of taxation. Under the corvée, the government ran no deficit: it got labor, and it laid out no cash. Still, we can certainly imagine that a tax paid in labor - or in any other outputs - could impoverish the private sector by reducing the income of those providing free service or by reducing the outputs available to the private sector. The result might be recession or inflation, depending on the balance between lost incomes and lost production.


Thus, we can see that the effect of government consumption on private activity depends not on whether the government pays for them, but on whether the resources consumed represent excess capacity.


But we can also imagine circumstances under which commandeering goods and services might not impoverish anyone. If the outputs being taken represent excess capacity, the private sector would truck along nicely despite the tax imposed. Indeed, if the government made good use of the things it takes, the economy would grow by virtue of these taxes. Thus, we can see that the effect of government consumption on private activity depends not on whether the government pays for them, but on whether the resources consumed represent excess capacity. I believe that's true regardless of how the government gets what it uses.

Government "Commandeering" the Unemployed

The revolution ended the corvée, but Wikipedia tells us that something like it was revived in France from time to time under the name prestation; every able bodied man had to give three days' labor or its money equivalent in order to be allowed to vote. Under a prestation, the decision to work or pay reflects the taxpayer's opportunity cost. If the man can earn more money than the prestation charge by working in the private sector for three days, then he will work in the private sector and, in effect, pay someone else to do his government service. But if the prestation charge exceeds what the man can earn elsewhere, he can take an unpaid government job for three days to satisfy his obligation.


Thus, the beauty of the prestation is that it uses excess capacity first, allowing those with good jobs to pay those without them.


The extreme case of the man who cannot earn more than the prestation charge in the private sector is the man who is unemployed. We can imagine, then, a situation in which unemployed men "pay" three days' labor, which costs them nothing, and the government uses the money paid by cash payers to hire men at the going wage to make up the rest of the needed workforce. In that scenario, the government has commandeered labor from the unemployed, which is a very efficient way to tax, and it has paid men who might or might not be unemployed with money taken from men who clearly are employed. Thus, the beauty of the prestation is that it uses excess capacity first, allowing those with good jobs to pay those without them. That's essentially how "cap and trade" systems work: those who cannot cheaply reduce their emissions pay those who can reduce their emissions cheaply. It's all just Coasian bargaining, with the excess capacity is tapped before the price of scarce resources is bid up.


If we assume that stable currency is our goal, then, under prestation, a balanced budget is exactly right only when workers are neither scarce nor abundant, a very rare occurrence.


Under prestation, as under corvée, the budget is balanced. The men who pay their tax by working cost the government nothing, and the money collected from the cash payers fully pays for the labor hired. Yet the macro consequences vary depending on how badly the workers are missed in the private economy. If these men are needed to make things, wages and prices rise, and inflation occurs. If they are not needed, then their contribution to the infrastructure makes things cheaper, and maybe prices fall. If we assume that stable currency is our goal, then, under prestation, a balanced budget is exactly right only when workers are neither scarce nor abundant, a very rare occurrence.

Prestation, A Form of Cap and Trade

Labor and emission reduction are like any other thing the government uses. If there is a lot of excess capacity, much of what the government uses could, in theory, be procured at no cost to the economy through a cap and trade prestation. But that's an awful clunky way for the government to proceed. Our taxes are payable only in cash and the government buys everything it uses. A statistically average avatar with excess capacity can sell that capacity to the government and use the resulting revenue to pay the dollar tax, thereby achieving the same result as tendering the excess capacity itself under a prestation. Thus, just as prestation results in a balanced budget, a money tax that results in a balanced budget is economically equivalent to a prestation, at least in terms of how the goods and services used by the government affect the private economy.

A Question of Fairness

All of these balanced budget models - corvée, prestation, and cash tax - are "unfair" to those who do not have excess capacity to offer the government. Those who have such capacity have no opportunity cost for paying their taxes, and are, therefore, subsidized by those who don't have such capacity and must surrender money or valuable time. The only way to minimize that unfair subsidy is to lower the tax, i.e., to run a budget deficit. But we don't like deficits, yet.

Ideally, the government would pay for what it uses at marginal opportunity cost. That way, the provision of goods and services by those who provide them would be a wash, and any cash tax imposed on everyone would be equally burdensome. The problem is that "marginal cost" cannot be measured at the procurement level. Some companies exist only to sell to the government. Such a company may have a very low marginal cost for the last item it sells, but the marginal cost of what it sells to the government is exactly equal to its average cost, because it sells everything it makes to the government. Accordingly, the government must pay average cost for everything it buys, raising the question of exactly what we mean by tapping "excess" capacity.

The Excess Capacity of the General Economy and Government Creation of Money

The excess capacity that the government can tap does not lie within the industrial sector that supplies the government. The excess capacity exists in the general economy, and we know it only by the absence of price pressure when demand for things increases. The trick is for the government to convert the excess capacity in the general economy into outputs the government can use. This is precisely what a medium of exchange is about: the government has too few guns, and the people have too much butter. If the government could somehow buy the butter but get the guns, the war effort would not destroy the economy. Surprisingly, there is a very simple way for the government to achieve that aim. All it has to do is pay for what it uses by printing money.


When the smoke clears, the government will, in effect, have obtained the value of the excess capacity in guns, but no one will have had to do without anything in order for that to happen.


To oversimplify, suppose that the government buys guns with new money, and the gun sellers all spend their revenues on butter, and the butter sellers spend their additional money on more butter, all of which has no marginal cost. When the smoke clears, the government will, in effect, have obtained the value of the excess capacity in guns, but no one will have had to do without anything in order for that to happen. The price of guns and the inputs thereto may have risen a bit to the extent that they were not in excess, but the general price level is largely unchanged.


... technological gain has come to dwarf the ebb and flow of the business cycle, much as it did in the late nineteenth century.


Of course, it's ridiculous to assume that everyone wants only the one thing that is in infinite supply, but the butter is a metaphor for all of the industries that have excess capacity. It is completely reasonable to assume that some of the new money printed by the government would be spent on abundant goods. Some of this abundance may reflect slack in the economy, but the real magic lies elsewhere, in the container ships, internet communication, and economic repurposing of billions of minds and bodies that are growing the output gap faster than government can fill it with demand. This technological gain has come to dwarf the ebb and flow of the business cycle, much as it did in the late nineteenth century.


If there were no scarce goods in the economy, government procurement could be funded entirely by new money.


Hard money types are fond of reminding us that inflation is a tax. But such folks are so anti-government that they think calling something a "tax" disqualifies it from further consideration. To which I say "Not so fast!" The whole point of money taxation is to prevent inflation. If there were no scarce goods in the economy, government procurement could be funded entirely by new money. Taxation removes that newly printed money back out of circulation so that the demand for scarce goods does not drive prices up unduly. But if the purpose of a money tax is to prevent another tax (inflation), should we not at least compare the two taxes to see how much of each we think best?

Much is said about central banks' inflation targets. However one comes out on that issue - I favor 2% inflation targeting - the arguments against inflation targeting are more sophisticated than a mere "It's a tax." All taxes are taxes, and unless all taxes are bad, one has to make a particular argument against inflation as a tax, and that's a difficult argument to make given all the benefits that central bankers can adduce for modest, predictable inflation.


With so much excess capacity available and more coming, we cannot take purchasing power from people on a dollar-for-dollar basis to offset government spending.


Don't Balance the Budget, Balance the Taxes

If the least burdensome tax is the one paid with excess capacity, and the excess capacity available in a modern economy is hidden throughout its sectors, the ideal tax will be one that ferrets out this capacity and delivers its value to the government. Inflation is such a tax. Before the inflation tax deprives anyone of anything, the new money scoops up all of the excess capacity for which anyone who touches it has any use. This is a brilliant device that imposes the best kind of tax while revealing how much other tax needs to be added. If, when the new money has permeated through the economy, the general price level has risen by 2%, the existing money tax level is just right. If the inflation rate is lower than 2%, then taxes need to be lowered. And, of course, if inflation is too high, taxes need to be raised. (In this special context, in which inflation is a "tax," so too is a higher risk-free interest rate, which imposes an excise on borrowing and, thereby suppresses demand just as a money tax.)

The problem with the inflation tax mediated by new money is that it requires a "deficit." Did I mention that we don't like deficits? Still, in times of excess capacity, monetized deficit spending is an infinitely better policy than a balanced budget. I believe that we have entered an era of reliable and growing excess capacity, an era in which modest inflation through a persistent, monetized deficit imposes the least burdensome adequate tax. With so much excess capacity available and more coming, we cannot take purchasing power from people on a dollar-for-dollar basis to offset government spending. To do so will deprive us of enormous bounty waiting to be produced and enjoyed.









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