Fly away Deficit Hawks & Deficit Doves: we've found the instruction manual

Deficit Hawks (usually on the political right) and Deficit Doves (usually on the left) both follow principles based on an out-dated and flawed understanding of state money. The good news is that we've rediscovered the monetary system instruction manual.

A quick reminder before we begin: a government deficit occurs when a government deposits more new money into bank accounts than they tax back out of existence. Such spending creates new money deposits for the private sector. Taxes removes some of that money. The "national debt" is the total accumulation over time of all money spent into existence by the government that has not been taxed out of existence. It represents the total net money savings of the private sector. 

Of course, this isn't how the Hawks & Doves talk, so let's summarize their views.

Deficit Hawks:

These folks think that budget deficits and the national debt are always bad and have a negative influence on the economy. Their perspective comes from the following beliefs:

1. Deficits are inflationary: they hold the (neoclassical) view that economies tend toward full employment through price adjustments/free markets, and since deficits increase aggregate demand (i.e. more spending power in the economy), they will cause prices to rise. (See here for inflation post).
2. Deficits make interest rates go up: they think that the government competes with the private sector for the limited pool of savings dollars. This competition for limited "savings" bids up interest rates.
3. Deficits reduce private investment: following the previous point, they therefore think that when savings get "used up" to fund government debt, it leaves less for the private sector and reduces their ability to invest. (See post on these points here).
4. The national debt leaves a burden for future generations: they somehow think that the next generation will have to pay off the "debt" left by our irresponsible choices, or at least leaving our children impoverished with the burden of huge interest payments. (See here.)
5. Government deficits & debts are irresponsible - even immoral: we have all heard the statements "if we ran our business or household like the government, we'd be bankrupt". The Hawks equate a currency-issuing nation with a household and believe they should manage their budgets the same way. 

Deficit Doves:

Now how about the Doves? They still wring their hands about the "problem" of debt and deficits in the long term, but they try to argue that they still aren't quite as bad as the Hawks think, and if we take a different time frame to deal with the problem, we can allow deficits today to help our economy in the short term. 

Here are their assumptions - and they do raise some good points along the way if our concern is just the size of the debt (which, of course, it isn't):

1. Let's inflation-adjust when we measure deficits & debt: this is one way to say that deficits really aren't as big as they seem if you measure today versus 50 years ago in total dollars - you have to look at debt-to-GDP ratios, and then it seems we can still afford more debt since the ratios aren't too much bigger.
2. The Federal Government doesn't keep a capital account and it owns assets: businesses show capital investments on their balance sheet and account for their use over time. For the government, it just shows up as money spent that year. Doves argue this makes the "debt" overstated.
3. What about intra- and inter- government debt? Some debt is "owed to itself" between government agencies so does that really count?
4. A lot of debt comes from unemployment: tax collections drop and welfare payments increase when there is a recession. Doves say it's not fair to count that as normal or irresponsible government deficit spending.
5. Why balance a budget over a year; why not a business cycle? There's nothing about a calendar year that makes sense for how government spending fluctuates. Doves look to ebb and flow over the ups and downs of the private sector, but still seek balance in the long run. 
6. Only the living pay and get paid, so we really don't burden future generations: since future generations will hold the debt too, they will be paying themselves, and they also benefit from any assets created by today's spending.
7. If there's any link between deficits and interest rates, it is reversed: Doves believe high interest rates cause deficits due to the higher interest payments.

With me so far? Have you identified your views along the way? Hopefully not, because both Hawks and Doves hold to a flawed view of government monetary operations.

Functional Finance (a.k.a. the Deficit Owls)

Stephanie Kelton has popularized the "Deficit Owl" terminology as a counter to the prevailing nonsensical alternatives (even with a fun YouTube book for children), but the ideas are not new. Most look back to the writings of Abba Lerner who explained the logical policy implications of how monetary systems actually function. 

So here are the basic principles that underlie the Deficit Owl "Instruction Manual":

1. The purpose of taxation in a modern monetary system is to create demand for (or give value to) the state currency.  This is so that the state can then spend that money into existence and provision resources for the purposes directed by the people. So taxes don't fund the government. 
2. The government has a monopoly on its money: the government has no need for the people's money; rather the people need the government's money, which only it can create. But, the government needs the people to need it's money - and that's why we have taxes! It's so that we accept the government's money in payment for goods and services. 
3. Selling government bonds has nothing to do with raising money for the government: this gets a bit technical, but the reason for bond sales it to keep the banking system from having too many reserves which would collapse the interest rate. It has nothing to do with raising funds for the government in order for it to spend. (See here.)
4. There is no real relationship between government spending and taxes: they are completely different operations serving different purposes, and each should be managed based solely on the effects that each operation has, not based on an artificial relationship between them (i.e. the "deficit").
5. The Hawks "sound money, sound finance" view treats modern money as though it were a gold standard: this simply isn't how anything works, and it hasn't been this way for a long time. 
6. The Doves are still wrong since even though they debate the size and cycle, they still give in to the Hawks that we ultimately need to balance budgets and manage the total size of our debt. We don't. We do need to manage the effect of our spending and taxing on the economy, so this is not a license to be irresponsible.  
7. The national debt is simply an accounting function: it is a balance sheet record of how many reserves have been removed from the banking system (and the flip side, it is a record of the total financial assets held (financial savings), mostly by private parties). It is nothing to fear. It is not a "debt" in the way a business or household thinks of debt (or a government without its own currency for that matter - Spain, Greece, etc. all gave up these options to the great detriment of their people). 
8. There is no future debt burden since the government, as a monopolist, can always pay its "debt" with the money it alone creates. It really just stops paying interest since "paying off the debt" just exchanges an interest-bearing "Treasury" with a reserve deposit at the Fed. (And of course it can always afford the interest payments since it creates those too!) But in fact there is unlikely a reason it will ever need to pay it off since the holders of that debt would lose the safest investment and their interest payments. 

The Instruction Manual

Sometime around the 1970's (likely due to the mistaken view that the oil crisis-led inflation was caused by too much government spending), we threw away the functional finance manual and have relied, miserably, on monetary policy alone. 

So how should we put this into practice? It's really quite simple and intuitive once you start with the correct premise. A currency-issuing nation has the ability to provision resources for its needs, but also the obligation to use that same system to keep the nation at full employment and to ensure there are no impediments to productive investment. In addition to the monetary policy of setting interest rates, this also means using fiscal policy via the effective adjustment of both taxation and spending - and casting off our debt/deficit fears.

So if the economy is in a downturn and there is insufficient spending to maintain growth, investment, and employment, then the correct "function" is some combination of lowering taxes and increasing spending. On the other hand, if demand is robust, investment is becoming speculative, and inflation is rising, then the appropriate "function" is a combination of increasing taxes (reducing spending power) and reducing government spending. Interest rate adjustments can still be somewhat useful for influencing investment but fiscal policy is the key.

Note that there is NO consideration here for the size of debt or deficits. It is simply irrelevant. What is relevant is the EFFECT of each operation on the economy. Too much spending and low taxes might one day cause inflation. That is an effect and should result in a change of function. Too little spending and too much taxation creates unemployment - that is the current effect of our lack of functional finance and reliance of the Hawks or Doves to lead us.

So join with the Owls. Teach your friends and children how money works. Let's free ourselves of the harmful and mythical practices that keep millions of our fellow citizens unemployed and that hold us back as a nation from investing in the necessary and beneficial capital, technology and services that we need to be prosperous, healthy, and free.