Dick Cheney, Modern Monetary Theorist, was mostly right

In 2002, Vice-President Dick Cheney told the Bush Administration’s economic team that “deficits don’t matter.” When the incident became public a few years later, he was lampooned in the press as an innumerate Neanderthal. Turns out, oddly enough, that he was mostly right and his persecutors were mostly wrong.

People who should know better often compare the government’s finances with those of a household. At first blush, the similarities are striking. When I want to spend more than I earn, I create a financial asset with the help of my bank to borrow money. When the government wants to spend more than it collects in taxes it creates a financial asset called a bond and sells it at an auction in exchange for money. So far, so good.

If you believed that the United States government faces the same constraints that I do, you would expect that years of large deficits and rising debts would cause interest payments to increase exponentially until we were forced to sell our national parks to the Chinese. This is a perpetual fear within the Establishment but it is entirely without merit.

The death spiral is not a myth (just ask the Greeks!) but it does not apply to the U.S. government. The worrywarts have to reconcile with two stubborn facts:

  • The Treasury is financing the largest debt burden ever recorded in peacetime

  • Net interest payments on federal debt are lower as a share of federal revenue than in the late 1990s, when surpluses were projected out as far as the eye could see

These phenomena could not coexist if the markets were worried about the government’s long-term fiscal position. So much for the “debt crisis.”

Why is this happening? The interest burden is the total debt of the government multiplied by the interest rate that investors demand for holding Treasury bonds. These securities are particularly attractive when the economy is sagging because they provide a guaranteed nominal cash flow. Thanks to the financial crisis, the U.S. private sector has been shoveling money into government debt, thus lowering funding costs. The yield on the 5-year note is representative of what happened:

Why has the deficit been so large? American households lost about $8 trillion of net worth with the collapse of the housing bubble. After decades of living beyond their means, they collectively decided to start saving more than they earned. This puts a lid on corporate revenue growth. When their sales forecasts are so bleak, companies have no good reason to spend—hence the choice to hoard cash. Of course, a weak domestic market would not have been a problem for them if foreigners had been willing to run trade deficits with the United States. In that situation, American households could have satisfied their desire to save by funding business investment and foreign consumption rather than the U.S. government. Unfortunately, the rest of the world has become so addicted to selling exports to the American consumer that the feds were forced to increase their own borrowing:

One conclusion is that the government will have no trouble funding yawning deficits if the economy stays depressed. Of course, if the economy does manage to recover, tax revenues will rise and spending on benefits for the poor will fall, which would probably offset any increase in interest rates. Either way, the outlook for the federal fisc is far from grim.

All this having been said, the government has had some help keeping its bills under control: the Federal Reserve funded about half of the $3.4 trillion in cumulative deficits generated since the start of the financial crisis. By law, all of the interest that it earns is placed directly into the Treasury’s account at the Fed, minus a tiny cut to cover staff salaries and other costs. Whatever interest rate the government “pays” on that debt is irrelevant since all the money goes straight back into its coffers anyway.

It should be clear that the U.S. federal government will never be forced into bankruptcy, unless the Fed—which is overseen by Congress—wants it. In fact, the government does not need to collect taxes in order to pay its bills. Thanks to the Fed, it can borrow unlimited amounts for as long as it wants without having to worry about even paying interest. For those worried about bankruptcy or the impact of the debt on future tax burdens, Cheney was right: deficits don’t matter.

Unfortunately, there is a catch. Just like any other bank, the Fed needs to create new liabilities to match additional assets, so if it buys government bonds it has to create an equivalent amount of deposits. Its depositors are banks (they keep their legally required reserves plus any “excess” reserves parked at the Fed) and the Treasury Department. In other words, the Fed lends to the government by printing money.

If this newly-printed money is then spent on real goods and services, the prices of those real goods and services will have to rise relative to the value of money. This is why most governments, most of the time, collect taxes rather than print what they need. Taxes restrict spending by the private sector and reduce competition for scarce resources, which helps keep prices stable. (Taxation is also used to encourage and discourage certain behaviors as well as reward and punish certain groups.)

It is important to point out that merely printing money does not create inflation. It is the spending that matters, not the sheer quantity of money. After all, if the money is not spent, how can it have an effect on prices?

A concrete example: most of the money that the Fed has printed since the start of the financial crisis is sitting inert in the form of excess reserves. You can see this in the chart below by observing that the gap between the red and blue lines has barely grown in the past three years:

This is why broader measures of the money supply like M2 have grown so much slower than the supply that the Fed directly controls (the red line):

The result has been much slower inflation (the blue line) than one might have expected given the scale of the Fed’s intervention:

So to recap:

  • Over the past several years, the Federal government has been running deficits bigger than any seen since WWII
  • Yet borrowing costs are lower now than they were when tax revenues were larger as a share of the total economy and the government was running a budget surplus
  • This is partly thanks to the Federal Reserve, which has funded about half of the government’s cumulative deficit since the fourth quarter of 2008
  • Despite all the money-printing, CPI inflation has been relatively tame because most of the money has stayed stuck in the Fed’s vaults.

Cheney looks vindicated: right now, deficits really don’t matter!


About Matthew C. Klein
I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.

One Response to Dick Cheney, Modern Monetary Theorist, was mostly right

  1. Archie Archbold says:

    Would you care to expand on the possible / likely future consequence of the “deficits that don’t matter”.

    What happens if interest rates rise? What do you think the likelihood is of this occuring over the next 5 or 10 years?

    As deficits grow are there winners & losers? Savers or borrowers? Large banks, companies, wage earners, welfare recipients, retirees, pensioners, etc?

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