EKIP– Expert Club for Economics and Politics A Different Opinion
Author: Murray Rothbard
(The EKIP proudly presents a translation of part of the essay " Ten Great Economic Myths " by the great American economist Murray Rothbard. In this part of his essay, Rothbard focuses on the three biggest myths regarding government budget deficits and the effects they have on the economy of each country.)
Myth 1. Deficits cause inflation; deficits have nothing to do with inflation
For the past few decades, the United States has consistently run a budget deficit. The opposition's response to this problem, regardless of which party has played that role, has always been to declare the deficit the main culprit for chronic inflation. And the invariable response to this criticism from the ruling party is always that inflation has nothing to do with the deficit. Both opposing claims are myths.
Having a deficit means that the government spends more than it collects through taxes. The difference between revenue and expenditure can be covered in two ways. If it is covered by issuing government bonds, the deficit does not lead to inflation. No new money is created; citizens and institutions withdraw from their bank deposits to pay for the bonds, and the treasury spends the collected money. Money is simply transferred from society to the government and is subsequently spent on specific services consumed by specific citizens.
On the other hand, the deficit can also be financed by selling bonds to the banking system. In this scenario, banks create new money by opening new bank deposits and using them to buy back bonds. This new money, taking the form of bank deposits, is subsequently spent by the government and permanently enters the economy in the form of new spending, which raises prices and causes inflation. Using complex financial mechanisms, the treasury allows banks to create new money based on one-tenth of their reserves. For example, if banks buy bonds for $100 billion, the treasury buys old bonds for $10 billion. This purchase increases the banks' reserves by $10 billion, allowing them to pyramidally create new deposits and money that equal the amount of these reserves multiplied by ten. In other words, the government and the banking system "print" new money to fill the budget deficit.
So, deficits are inflationary to the extent that they are financed through the banking system; they do NOT cause inflation to the extent that they are covered by the citizens.
Some experts point to the period 1982-83, when deficits were growing and inflation was falling, as statistical “proof” that deficits and inflation have nothing to do with each other. However, this is not proof at all. Price dynamics are determined by two factors: the supply and demand for money. In the period 1982-83, the Federal Reserve (the central bank of the United States) created new money at an accelerated pace, recording about 15% growth in the money supply per year. Much of this money was directed to financing the deficit. On the other hand, the severe depression of the same period had created an increased demand for money (that is, it had reduced the desire to spend money on goods and services) due to heavy losses for businesses. This temporary surge in the demand for money, which otherwise offsets the inflationary effect of the faster printing of new money by the Fed, does not make deficits less inflationary. In fact, once recovery from crisis and depression begins, spending begins to increase again, the demand for money falls, and this accelerates the pace of inflation.
Myth 2: Deficits do not drive productive private investment
In recent years, there have been understandable concerns about the low levels of savings and investment in the United States. One such concern is that huge government deficits will divert citizens’ savings into unproductive government spending and therefore crowd out productive private investment. This would create even more problems in the long run in terms of improving or even maintaining current levels of living standards for citizens.
Some politicians are once again trying to refute this thesis using statistics. They argue that the fact that in 1982-83 interest rates were falling while deficits were large and growing proves that government deficits do not crowd out, and consequently reduce, private investment.
This argument once again demonstrates the fallacy of trying to refute logic with statistics. Interest rates then fell because of the decline in business borrowing caused by the recession. “Real” interest rates (interest rates minus the rate of inflation) remained extremely high, however, partly because most of us expected hyperinflation, and partly because of the crowding out of private investment. In any case, statistics cannot refute logic. And logic tells us that if citizens’ savings are spent on government bonds, then less savings will be used to finance productive investment than would otherwise be the case, and interest rates will be higher than they would be without a deficit. If the deficit is financed by taxpayers, then the diversion of savings to government projects is direct and quite obvious. On the other hand, if the deficit is financed through bank inflation, then the diversion is indirect – the crowding out of private investment in this situation is done through the newly printed money by the government, which competes for the same resources with the citizens' old money.
Milton Friedman attempted to deny the crowding-out effect of deficits by arguing that all government spending, not just deficits, crowd out private savings and investment to the same extent. It is true that money “drained” through taxes could also go to private savings and investment if it were not confiscated. But deficits have a much greater crowding-out effect than ordinary government spending. This is because deficits financed by citizens clearly only drain savings, while taxes reduce public consumption along with savings.
Thus, deficits, no matter how you look at them, cause serious economic problems. If they are financed by the banking system, they cause inflation. But even if they are financed directly by citizens, they cause significant crowding-out effects, diverting savings from financing needed private investment to wasteful government projects. Moreover, the larger the deficits, the greater the permanent income tax burden on American citizens, who ultimately have to pay for the government's increasing interest costs. The latter is a problem that is further exacerbated by the high interest rates caused by inflationary deficits.
Myth 3: Raising taxes is an appropriate solution to the deficit
Some of those who are, quite rightly, concerned about the deficit and its inflationary effects, unfortunately propose an unacceptable solution: raising taxes. Trying to solve the deficit problem by raising taxes is like shooting a man with bronchitis. The “cure” for the disease is worse than the disease itself.
For starters, as many critics have pointed out, raising taxes simply gives the government more money. As a result, politicians and bureaucrats are more likely to increase spending than to cut it. Parkinson put it in his famous rule: “Spending goes up to meet income.” If the government is willing to finance, say, a 20% deficit, it will “cope” with the higher income by increasing spending even more to maintain the same deficit rate.
But even setting aside this obvious rule of political psychology, why would anyone even think that a tax increase is preferable to a price increase? It is true that inflation is effectively a form of hidden taxation, in which the government and other first recipients of new money seize purchasing power from taxpayers whose incomes rise later in the inflation process. But at least with inflation people can still benefit from voluntary exchange in the market. If the price of bread jumps to $10 a loaf, that is bad, but at least you can still eat bread. If taxes go up, on the other hand, your money is irretrievably seized in favor of politicians and bureaucrats. And then you can buy nothing with that money. The only result is that the producers' money is confiscated for the benefit of the bureaucracy, which only worsens the situation by using some of this confiscated money to defraud and repress citizens.
The only sensible solution to deficits is simple, but practically unmentioned: cutting the state budget. How and where? Anyway, wherever.
Translated from English: Kaloyan Pravov, Natalia Chomakova
Image source: Forbes.com
