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 Created: 28 Jul 2011  Copyright © 2011 by owner.
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Modified: 26 Oct 2013 

Economics for the Lay Person


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Balance the Federal Budget
But Not in the Middle of a Recession!


The Nature of Conventional Budgeting

Everyone knows it's good practice for households and businesses to keep their budgets balanced, which is to say that the amount of money taken in equals the amount spent.  Some might not understand exactly why this is important or how the theory works, but most adults are aware from experience—either their own or someone else's—that failure to keep spending in line with income can lead to severe financial difficulty at some point.

Now, given that most of us can't realistically anticipate every penny of income or expense, this would be an extremely difficult task, were it not for the accounting convention of treating money saved as a liability (wealth owed) and money borrowed as an asset (wealth owned).  To the accounting neophyte, this seems counterintuitive:  Saving money implies the privilege to reacquire money that already belongs to us, whereas borrowing money implies an obligation to pay back money that belongs to someone else.  But think of it this way:  Money borrowed functions as a form of (temporary) income to the borrower, whereas paying borrowed money back to the lender is an expense for the borrower.  Now think of savings as a kind of reverse borrowing; by saving money in a bank, we are in fact temporarily lending our money to the bank, and the bank is obligated to pay it back to us eventually.  So, we can view the cash flow of saving as a mirror image of the cash flow of borrowing, since the saver acts as a lender and the bank as a borrower.

In the final analysis, taking out a loan or drawing money out of savings puts cash into the pocket of the borrower or saver, and thus counts as income.  Making loan payments or depositing money into savings takes cash out of the borrower's or saver's pocket, and thus counts as an expense.  Where accounting and budgets are concerned, the effect of both saving and borrowing is to act as a buffer that absorbs the moment-to-moment differences between actual inflow and outflow of cash.  Budgeting allows us to ensure that income and expenses remain in manageable accord, with borrowing or saving taking up the slack between the two.

Balancing a budget is a long-term project.  From moment to moment, our income might be greater than our expenses (on payday), or our expenses might be greater than our income (when we buy groceries or pay bills).  Budget-balancing occurs over a period of time, typically from payday to payday, or over the span of a year or two.  The important consideration is that overall income over some specified period equals overall expenses over that same period.  If instead we ring up debt without regularly paying it down, we eventually find ourselves in the dicey situation of owing more than we own.  And if the interest and required payments on what we owe exceed our income, we're in serious trouble.  This is an unsustainable state of affairs for any household or business, or even for a local or state government, and declaring bankruptcy may be the only practical way out.


Is What's Good for Households and Businesses also Good for Government?

So, we'd expect that the rules that work for households and businesses ought to be the same for government as well, right?  Well, yes, it's still generally a good idea for government to aim for something fairly close to an overall budgetary balance over a decade or two.  For example, government might run a deficit to pay for a war or for disaster relief, and when times are better it would run a modest surplus to pay down the earlier debt and build a reserve for future tough times.

But government is neither a household nor a business, in concept, design, or function.  In some respects, budgeting is very different for an entity that, by deliberate design, operates (ideally) on behalf of all the people and is entrusted with the unique power to create money and to regulate its supply.  Used wisely, such power is a good thing, for it allows government the flexibility to operate at a deficit (to spend more than it takes in) not only when emergencies arise, but also to stimulate spending in an economic recession; or at a surplus (to take in more than it spends) not only to build an emergency fund, but also to curb inflation.  Without such unique powers, government would find itself unable to deal with economic recession or inflation, and would have to look on helplessly as they run their destructive courses.


Economic Fluctuation

Left to themselves, naturally occurring inflationary and recessionary eddies in the economy tend to become not only self-sustaining but self-escalating spirals.  This owes in large part to the fact that human emotion—avarice and apprehension—plays a prominent role in motivating markets, whether to buy or to sell.  Emotion feeds on itself, and spreads from person to person, from group to group.  Optimism evolves from hopeful expectation into "irrational exuberance,"1 and pessimism grows from prudent caution into anxiety and raw panic.  Emotions are profoundly human—so much so that they're echoed in automated market trading software, which accelerates and magnifies their effects (producing such phenomena as the "flash crash").  Although emotion may be irrelevant in logic, its effects are nonetheless all too real, and can do enormous economic and social damage.  Emotion and psychology must thus be counted serious factors in the economic ebb and flow; they cannot be simply dismissed or ruled out of the equation.

Even so, economists assure us that, in the very long term, a free-market economy is self-regulating.  Despite fluctuations, it tends to move gradually toward equilibrium.  The problem is that the time required for a large national economy to recover naturally from a major fluctuation might be measured, not in months or even in years, but in generations.  But life is short, and time is precious.  Families whose jobs have been lost and whose savings have been wiped out in a recession simply can't wait generations to be able to afford decent food, shelter, clothing, and education for the kids.  Businesses can't wait generations to sell accumulated inventory.  Banks can't wait for generations to have loans repaid.  Retirees can't wait generations for their pension funds and investment accounts to recover.  For an economic system to be of reliable, practical use within human timeframes, some form of artificial regulation must be introduced to counteract fluctuations and to accelerate the restoration of equilibrium.  So, government needs tools to identify and deal effectively with economic spirals, and the ability to control the supply of money in circulation is among the most powerful of these tools.


The Futility of a Balanced-Budget Amendment

The fundamental problem with virtually all balanced-budget amendment proposals is that they're drawn up, not by economists, but by politicians with little or no understanding of macroeconomics, or even a head-full of bogus economic ideology.  Most politicians understand the simple necessity of allowing the nation to spend more than it takes in during an emergency—a war or a series of disasters—and would write such provisions into an amendment proposal.  Most of them know something of basic concepts of supply and demand in the business world.  But like most people, many politicians are mystified by the national and global economics of inflation and recession, trading markets, the banking system, and the Federal Reserve.  (Some even suppose that the Federal Reserve is part of a socialist plot to cripple the free-market system and stifle entrepreneurship.)  Because they haven't bothered to study how economics actually works, many are charmed by the notion that balancing the budget will magically remedy all economic ailments—a notion resulting from a confusion of cause and effect, when in fact, a balanced budget is the effect, not the cause, of a well-tuned economy.  Indeed, it's a matter of historical record that attempting to balance the national budget when the economy is in recession or recovery (as in 1937, 1960, and 2011) actually exacerbates recession and delays recovery.  Being thus severely misinformed and mystified, these misguided politicians fail to take into consideration all the real-world implications of a mandate to balance the federal budget.

A constitutional amendment requiring the federal budget to be in perpetual balance would deprive government of this stabilizing power.  Our economic system would lose the huge deficit-surplus buffer it needs in order to cushion and counteract the enormous cyclical tera-dollar waves of instability that inevitably develop in a market system free to respond to impulses of greed and panic to the exclusion of all other concerns.  Without government's ability to put more money into circulation (by spending more than it takes in), our economy could be locked into a recessionary spiral lasting decades.  And without government's ability to take money out of circulation (by taking in more than it spends), an inflationary spiral could run out of control, eroding the buying power of money and ultimately making it worth less than the paper on which it's printed (as has happened in countries that lack our system of monetary regulation, and as has happened even in our own country when those in charge have failed to use that system well or even tried to dismantle it).


The Additional Matter of Inflation

Even if government could exactly balance what it spends and what it takes in, many economists believe that to do so would be unwise.  The reason is that inflation and government deficit spending are closely related.  Bringing the budget into long term balance would tend to drop the inflation rate to a very low level.  But wouldn't this be a good thing?  Isn't inflation always bad?

Whatever its unpleasant effects, one benefit of a moderate rate of inflation is to encourage people to buy sooner rather than later (because they expect prices to increase later, so feel they can get a better deal now).  A little inflation thus tends to keep money in active circulation, thus keep consumer demand stable, which prompts business to maintain production and keep workers employed.  This is obviously a good thing.  But inflation naturally varies a bit, as a result of such things as day-to-day market fluctuations, variables in the resource supply chain, and periodic labor negotiations.  So, even if we tried to peg inflation exactly at zero, it wouldn't stay there.  Natural fluctuations would sometimes shift it slightly positive or negative.

Now, moderately positive inflation is tolerable.  But even slightly negative inflation—deflation—can produce disastrous effects.  When inflation turns negative, that means that prices have begun to fall.  That's good, right?  It seems good to the consumer, at least for the first few days.  But falling prices are a harbinger of economic panic in the business world.  They have a damping effect on buying psychology opposite to the urging effect of rising prices.  Once consumers get into the habit of thinking that prices will get even lower tomorrow, or next month, or next year (in other words, that the buying power of their money will increase over time), they actually stop buying virtually everything except daily essentials.  They hold onto their money, rather than spend it, because they anticipate it'll buy more if they wait.  When this money goes out of circulation on a large scale, consumer demand drops, production slows, profits slump, workers get laid off.  When dividends shrink and wages are lost, the affected investors and workers get even more cautious about spending.  Consumer demand drops further, a recessionary spiral rapidly sets in, and from there on the outlook gets really ugly really fast.

So, if we want to avoid economic downturns, history has shown that a slight upward inflationary pressure turns out to be a good thing, because it discourages hoarding and the market stagnation that accompanies it.  Still, this doesn't mean that we can't run a moderate surplus when the economy is booming; in fact, it's economically desirable2 to pay down accumulated debt, and doing so in times of prosperity can help keep that prosperity from morphing into a market bubble or an inflationary spiral.  We must just be watchful as the rise of prices slows, adjust monetary policy as inflation approaches zero, and alter policy if prices show any hint of systemic decline beyond routine sales and discounts.


Realistic Goals

So, what we want to set as our long-range goal is not a perfectly balanced national budget, but one that in normal times gives a modest edge to deficit spending, so long as the deficit is monitored and maintained as a percentage of gross domestic product.  Although this might be sacrilege to the ears of balanced-budget ideologues, it's a practical, sustainable, and even prudent stance in the real economic world.  That's why, although a balanced budget amendment might seem a noble gesture on paper (or on a bumper sticker), it's a shortsighted and untenable notion in practice; we'd begin to regret it soon after it went into effect.  Moreover, as we've already pointed out, an out-of-balance budget is merely a symptom of a problem, not the problem itself.  If we're to deal realistically with budgetary imbalances (and at some point indeed we must), then we must deal, not with the symptoms, but with the problems that cause them.

There's little disagreement that imbalance in the federal budget arises largely from government's tendency nowadays, given even the feeblest excuse, to spend more than it takes in, often in an effort by incumbent politicians to channel projects and money to their home states and districts in order to please their constituent voters.  One way to address this problem would be for government to adopt strict rules, requiring every item of spending legislation and regulatory activity to specify not only the benefits it's expected to produce, but also its anticipated costs and the revenue sources needed to initiate and support it, and to require that taxes or fees be adjusted accordingly to provide adequate funding.  And in the not at all unlikely event that actual costs run above or below estimates, subsequent adjustments, either to revenue or to the program itself, would be required in order to compensate.  In other words, each government program ought to be considered as a whole, costs and funding included.

We readily concede that there might be other, better ways to address the problem of ballooning government debt.  But a balanced-budget amendment isn't one of them.  Such an amendment would set us flailing ineffectually at symptoms while ignoring the problem, and at the same time leave us defenseless against devastating boom-and-bust cycles.  Our proposal to require funding provisions as an integral part of government programs, on the other hand, might serve as a starting point for rational discussion and development of realistic and workable solutions to the actual problems that cause budget imbalance.

=SAJ=


NOTES

1. "Irrational exuberance" is a term coined in the 1990s by Federal Reserve Chairman Alan Greenspan, in reference to rapid "bubble" growth in market prices without corresponding increases in substantive value.

2. While it's economically advisable and responsible for government to run a surplus during a prosperous period, nobody wants to be the one to "rain on the party."  So, most politicians tend to shy away from budget surpluses, even though, when properly timed, they're in everyone's long-term best interest.  This is the long-term reason that, instead of fluctuating in synch with the economy,  the national debt tends to grow almost incessantly.

 


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