Commetary: CBO Still Dead Wrong on the Budget

CBO has released another one of its long term budget outlooks.  It’s a 132 page document choke full of graphs and figures to help Congress make fiscal policy.  A lot more is going on ‘under the hood.’  Thousands of man hours went into developing the methodologies to make the projections.  I neither endorse nor dispute the quality of these projections.  Sadly, it’s not necessary.  That’s because CBO lays out its basic assumptions and framework through which it views the task of fiscal policy makers.  It’s a laughably incomplete and obsolete set of principles which still sees the world on a gold standard, propagates myths about the banking system, and ignores history. 

The best way to dispatch this whopper of a report is simply focus on exactly what CBO says.  Specifically, three bullet points early in the document lay out why Congress should care about the long term path of the debt and the deficit.  We’ll cover them in order:

“The large amount of federal borrowing would draw money away from private investment in productive capital over the long term, because the portion of people’s savings used to buy government securities would not be available to finance private investment. The result would be a smaller stock of capital, and therefore lower output and income, than would otherwise have been the case, all else being equal.” 

 

Again, here we see the tired long refuted idea that banks act as intermediaries between borrowers and savers.  In reality, because modern central banks play an accommodative role in providing sufficient reserve balances to the financial system, banks create new purchasing power ex nihilo.  Indeed, the old model of banking described in the textbooks is mythological. 

 

It is true that the sale of government securities does indeed reduce the aggregate reserve balance of the banking sector, but the Federal Reserve can and does act to ensure that Treasury Auctions do not interfere with monetary policy.  Usually, this means engaging in defensive purchases of existing Treasury assets to ensure that the reserve drainage caused by Treasury Auctions does not disrupt the banking system by making short term interest rates rise. 

 

Furthermore, although the Treasury is selling assets and the Fed is buying them, the consolidated government is really just executing offsetting open market operations.  Thus, both short term interest rates and therefore the cost of credit creation are not affected.  

 

So long as the Fed has an accommodative policy in terms of providing such reserves as are necessary to allow the banking sector to both settle payments and create credit at the stipulated cost (the Fed Funds Rate), no amount of government spending or debt could ever crowd out private sector borrowing or investment.

 

“Federal spending on interest payments would rise ,thus requiring the government to raise taxes, reduce spending for benefits and services, or both to achieve any targets that it might choose for budget deficits and debt.”

 

No. The government does not face a tradeoff between making interest payments and paying public benefits.  Because the US government spends in its own currency, no binding constraint exists on nominal spending.  The cost of government spending is an opportunity cost.  The real resources (man power, output) assigned to the government for public purpose cannot be put to private use.  However, government payments to purchase financial assets or pay interest do not remove any real wealth from the private sector.  The first order effect of these transactions is therefore not to raise the price level in the real economy.  Nothing stops the US Treasury from continuing to paying interest by issuing more securities, just like the Fed is currently paying interest on reserves by issuing more reserves!  Yet again, the CBO makes lazy assumptions, seeing all government payments as equal both in terms of their inflationary effects and therefore assumes that all spending must ultimately be financed with taxes.

 

“The large amount of debt would restrict policymakers’ability to use tax and spending policies to respond to unexpected challenges, such as economic downturns or financial crises. As a result, those challenges would tend to have larger negative effects on the economy and on people’s well-being than they would otherwise.The large amount of debt could also compromise national security by constraining defense spending in times of international crisis or by limiting the country’s ability to prepare for such a crisis.”

 

This last point has been made before by the CBO, and it’s still a pot-pourri of partisan hat tipping.  It’s painfully obvious that the words ‘people’s well-being’ are aimed directly and Democrats while reference to national defense is geared towards Republicans.  In any case, if we ever let the national debt constrain the war fighting capacity of the country, we might as well give Texas and California back to Mexico and then surrender to the Russians.   In a stunning rewriting of history, CBO believes that the US government, or any government for that matter, has ‘constrained’ its spending during wartime.  In reality, every major war fought by the United States has been financed by the printing press. 

 

The Continental Congress printed up Continental dollars to finance the revolution.  Abraham Lincoln established the Office of the Comptroller of the Currency to print the dollars necessary to finance the Civil War.  By the Second World War, things had gotten a bit more sophisticated.  The Federal Reserve pegged Treasury rates at 0.375 percent  via massive bond purchases, which were financed by crediting bank accounts with dollars created by an accountant’s pen.  In sum, the power of money creation means that the nominal spending of monetary sovereigns is never constrained.  While it is true that periods of very high to severe inflation followed each of the above episodes, the extent to which the inflation was caused by money creation is unclear.  Surely, the removal of productive capacity from the economy to help with the war effort only exacerbated the inflationary pressure on the economy.  

 

In any event, neither potential inflation nor the national debt could ever prevent the US government from marshalling enough forces to fight a war or defend the nation.   Rest assured, if the Canadian Mounties ever occupied my native Minneapolis, the United States would have the real military assets to dislodge them, regardless of government finances.

 

While the CBO is supposedly highly respected by both sides of Congress, that says more about the sorrow state of political discourse and economic thinking in the twenty first century.  The CBO’s tired and outdated mode of thinking is only adding to the noise and confusion surrounding important issues that face the country when it comes to fiscal and economic policy.