Let's Play 'Conventional Wisdom'
Public radio plays an online game ... but what's it based on?
In the first post on this Substack blog, I said that our goal would be
"... to understand the economy better, but -- of equal importance -- ... to understand how the political economy is discussed in the media and on the internet. We will read news articles, analytic pieces and opinion columns critically, exposing the ideological perspectives lying underneath them."
With that in mind, let's take a listen to public radio show Marketplace. On March 8, Marketplace presented a segment, "Can you build a sustainable federal budget", about an online game, "The Fiscal Ship," which "lets players make their own federal budget proposal."
This game was created by the Hutchins Center on Fiscal and Monetary Policy. The Hutchins Center is a subsidiary of The Brookings Institution, the oldest and most deliberately centrist of all Washington think-tanks. The Hutchins Board of Advisors is led by Harvard economist and best-selling textbook author N. Gregory Mankiw and Harvard economist/former Harvard president/former Secretary of the Treasury Lawrence Summers. The Board includes former Federal Reserve Chair Ben Bernanke, former New York Federal Reserve Bank Chair Bill Dudley, and Laurence Fink, CEO of BlackRock, the world's largest asset management company.
Baby, at Hutchins we're talking Ruling Class! Aspiring policy wonks, prepare to click through to a Brookings fellowship!
Marketplace host Kai Ryssdal was guided through "The Fiscal Ship" game by Hutchins Center policy director Louise Sheiner. To be fair, playing the game does require you to specify your governing goals, which implicitly requires you to specify your political and social values. But once you've done that, "winning" the game is defined quite narrowly as balancing the federal budget over a twenty-five-year time-frame.
The key metric in measuring whether you're "winning" or not is the ratio of federal debt to gross domestic product. As Sheiner put it, the goal of the game is, "Find the policies that are consistent with your values that stabilize the debt to GDP ratio in twenty-five years at today's level."
Today's debt/GDP level is roughly 120%, double what it was before the Great Recession in 2007-08. Why is the debt/GDP ratio important?, host Ryssdal asks. "Why is that the thing?" Ms. Sheiner replies,
"So, eventually we have to stabilize our debt/GDP ratio in the sense that we can't keep on borrowing more and more and more. As the debt increases, we have interest rates increasing, and we're gonna have to divert more and more of our spending toward payment [of] interest and you can't keep on borrowing indefinitely. At some point people are going to say you're not gonna pay it back. So we eventually have to stabilize the debt/GDP ratio."1
Sheiner concedes that to set the game's goal at stabilizing the debt/GDP ratio at today's level is somewhat arbitrary, but that's okay because this is, after all, just a game.
Ryssdal starts to play the game, makes various policy choices and discovers how difficult it is to stabilize the debt/GDP ratio. Sheiner says that that indicates that "we have to make some hard choices, not some little, easy choices." She suggests the need for large tax increases and new kinds of taxes such as carbon taxes.
Ryssdal opines that in this country we have a history of not paying for all the things we want, to which Sheiner responds that the debt/GDP ratio was stable for a long time but increased greatly during Great Recession and again during the pandemic. Interest rates were low for a long time, but higher interest rates since mid-2021 make paying interest on the debt more burdensome.
"The Fiscal Ship" game has been online since 2016, but this Marketplace report was my first hearing of it. What struck me about the game was how well it encapsulates the conventional wisdom about federal spending, "deficits" and the national "debt." The same attitudes were expressed the very next day in the Washington Post's lead editorial, "The United States has a debt problem. Biden’s budget won’t solve it." and in a series of articles on the Biden administration's budget proposals in The New York Times written or co-written by Jim Tankersley.2
When we carefully examine the conventional wisdom, however, it falls apart. To understand why, we're going to have to take a detour away from the federal government into state government. We're also going to detour away from what we usually think of as "borrowing" and "debt." Fasten your seat belts!
What We Usually Think of as Borrowing
Let's suppose that you are the head of a state government agency tasked with improving your state's power transmission infrastructure in preparation for large-scale adoption of electric autos in response to climate change. (Since I live in New York state, we will, for argument's sake, assume that this agency is the New York Power Authority (NYPA).) The capital improvements you need are very large. The upfront construction costs are also very large, but the revenue you get from selling electricity only comes in over a 30-year time period.
So to finance the construction you, NYPA, borrow by selling 30-year bonds in public auctions. To put this a bit more formally: NYPA issues debt instruments (fancy term: promissory notes; non-fancy term: IOUs). You can't begin construction of new power lines until those bond sales have taken place. As for the money you raised in those bond sales, you don't need to know where or how that money was originally created. The money pre-existed your bond sale, but now that you have amassed it, you can spend it. Two other points: When you conducted those public auctions of your bonds, you had to take whatever interest rate the market was offering for them. And if, over the lifetime of those bonds, the revenue you get from, say, electric vehicle recharging fees doesn't cover the cost of interest payments on those bonds, you will be at risk of defaulting on them. Even if you don't default on those bonds, your lenders may refuse to purchase new bonds from you.
In economic terms, we can say that you, NYPA, are a currency user. As such you are like any individual household or business. A currency user has to amass funds before it can spend. Households amass funds via selling their members' ability to work for wages or salaries. Businesses amass funds via sales. State and local governments amass funds via taxation. If any of these ways of raising revenue does not cover planned expenses, one must resort to borrowing. While you can shop around for the best loan deal, the overall level of interest rates is largely outside your control. If your income doesn't cover the interest cost on those loans, you are at risk of defaulting on them and may be forced to file for bankruptcy. Even if you don't default on your loans, your creditors may refuse to extend you new loans.
The Household Budget Analogy
Still with me? Let's now turn back to the Hutchins Center and its online game. The "Fiscal Ship" game is built on the belief that federal government spending works just the same as spending by individual households, firms, and state and local governments. We call this belief the "Household Budget Analogy." The Household Budget Analogy runs like this:
Like households, firms, and state and local governments, the federal government starts out with no money of its own creation. It therefore must amass funds from some sources outside of itself before it can spend.
Like households, firms, and state and local governments, the federal government has to "borrow" if its regular sources of revenue (taxes) are insufficient to cover expenditures. The borrowing will take the form of issuance of debt instruments, e.g., auctions of Treasury bonds.
If the federal government "borrows too much," interest payments will be excessive and the government might be unable to cover them.
If the federal government "borrows too much," eventually its lenders will stop lending to it (i.e., stop purchasing Treasury bonds at auction). In the worst case, the federal government will run out of money and have to declare bankruptcy.
In orthodox economics, the federal government is supposed to avoid "borrowing too much" by keeping "borrowing" in proportion to the overall growth of the economy as measured by the Gross Domestic Product. Hence, the focus on the debt/GDP ratio. The assumption is that given a certain level of output in the economy, a certain amount of federal spending in excess of revenue is "sustainable"; "excessive" growth of debt relative to GDP is not. Hence, Sheiner is afraid of the "explosive" growth in the debt/GDP ratio since just before the Great Recession and her desire to see that ratio "stabilized."
The Federal Government's Budget Is Not Like a Household's Or a State Government's
To counterpose the conventional wisdom about the federal budget, we're going to draw upon the school of thought known as Modern Monetary Theory (or, more precisely, Modern Money Theory) -- MMT for short. Since this is a blog post and not a chapter in a political economy textbook, our explanation of MMT will be somewhat simplified and perhaps somewhat puzzling at first. Ask questions in the Comments.
We'll start off with four questions which we will ask you to think about, but we won't attempt to provide complete answers right now. Then we'll post some bullet points that address the ideas raised in the Household Budget Analogy bullet points above.
Think About These Four Questions
Between 2020 and 2022, Congress passed laws which, in response to the economic disruption caused by the COVID-19 pandemic, sent large checks (or sometimes direct deposits) to all U.S. households. Did the federal government have to amass funds before it sent out those checks?
At the start of World War II, in the wake of Pearl Harbor and Nazi Germany's declaration of war on the United States, did the U.S. Treasury have to wait to amass funds via either taxation of bond sales before it could start to spend on wartime production?
Ms. Sheiner asserts that "we [the federal government] can't keep on borrowing more and more and more." But the U.S. government has been doing just that ever since 1789! Almost every year, we spend more than we take back in taxes -- and people have been buying U.S. Treasury bonds during all that time! If we haven't driven off the fiscal cliff in 233 years, why should we be panicking about doing that now?
Ms. Sheiner asserts that the increase in the debt/GDP ratio over the last 15 years is something to be deeply worried about. But that ratio for the U.S. is still only half of Japan's debt/GDP ratio -- and Japan's interest rates are now a lot lower than the U.S.'s and Japan is not a poor country. So what's the big fuss about?
The Economy as Seen by Modern Money Theory
As indicated above, we'll just post these in bullet-point format for now.
Unlike households, firms, and state and local governments, the federal government does not need to amass funds from sources outside of itself before it can spend. The federal government is endowed by the Constitution with the power to create money. It is a currency-issuing level of government. The federal government creates money when it spends (which it does nowadays by using computer keystrokes to increment the bank accounts of the people from whom it is buying goods and services). The money which it injects into the economy via that spending is drawn back to the government via taxation. Indeed, since taxes are assessed in the currency created by the government, to pay your taxes you have to amass currency created when the government spent it into the economy. At the federal level, spending precedes taxation.
It doesn't really make sense to say that, when the U.S. Treasury auctions off bonds, it is "borrowing money" from some place or entity outside of itself. After all, when you purchase those bonds at auction, you are paying for them with currency that was originally created by the federal government itself. Bond sales, like taxation, therefore serve to drain money from the economy that the government originally injected into the economy by spending it.
The federal government is not at the mercy of the markets with respect to the rate of interest it pays on bonds. Our central bank, the Federal Reserve, has virtually complete control over basic short-term interest rates and always enjoys considerable influence over longer-term interest rates. During World War II, the Federal Reserve held long-term interest rates at a low level by agreement with the Treasury. Nowadays, Japan's government and central bank coordinate on both short-term and long-term interest rates.
The federal government is not at the mercy of "bond vigilantes." The United States is a monetarily sovereign nation. It controls its own currency. Its government does not peg the value of its currency to that of any other country or to any material object. Its government does not borrow in the currencies of other countries. Hence it can meet all payments for principal or interest when they come due indefinitely into the future.
Conclusion
Both the "Fiscal Ship" game discussed on Marketplace and discussion of the federal budget in the mainstream media over the past week rest upon a set of assumptions we've described as the Household Budget Analogy. The Household Budget Analogy forms an important part of the conventional wisdom about federal spending and debt. Both the Democratic and Republican parties, to somewhat differing extents, believe in the Household Budget Analogy. They accept it as setting the terms of discussion about the budget.
The Household Budget Analogy is, however, false. Unlike households, firms, and state and local governments, the federal government can never run out of money because it is a monetarily sovereign, currency-issuing level of government. The federal government is constrained in pursuit of the public purpose by the real resources the United States can mobilize and by the policies we place upon it through the political process -- but the federal government is not financially constrained. This is the starting point of an informed discussion of what we want the federal government to do on our behalf.
My transcription from playback.