Submitted by Taps Coogan on the 7th of October 2019 to The Sounding Line.
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For every $100 of government spending, the government must recuperate $100 from taxpayers and investors. The more the government spends, the more it must collect in taxes and bonds. Bigger deficits simply mean the government recuperates more of its spending via bonds and less via taxes. It still recuperates every dollar that it spends every year.
The money supply in the economy is not a function of government spending or deficits. The money supply is a function of the size of the monetary base (the Fed’s balance sheet) and bank lending ratios which are independent from government spending. Point in case, the monetary base has shrunk by roughly $500 billion since 2014 while runaway spending has increased the national debt by almost $4 trillion.
Bank lending is a function of the size of bank reserves (a function of the monetary base and savers’ willingness to hold deposits) and banks’ ability to lend. Neither of these factors are driven by government spending levels or deficits.
When the government runs large deficits and issues a correspondingly large amount of bonds, those bonds tie up capital that would otherwise have served as the assets upon which banks lend into the economy, or capital that investors would have lent into the private sector.
As we have noted before, there are only two scenarios when government spending can be stimulative. Neither scenario applies today.
The first scenario is when the central bank performs QE and prints money in order to purchase government bonds. In that case, deficit spending increases the money supply and thus the overall demand for goods and services in the economy. However, the real stimulus in this situation comes from the central bank and its QE, which can be done regardless of whether the government is running a deficit today, so long as it has outstanding bonds. The Fed can, and does, monetize other assets as well, such as mortgage-backed securities.
The second scenario is if banks and investors are unwilling to lend and invest in the economy and there is an excess of capital serving no productive function. This typically only happens during acute recessions.
Neither of those conditions are present today.
In light of this, today’s talk of using fiscal stimulus in the US and Europe to supplement the diminishing potency of monetary policy is a dead-end. Not only will it not deliver the desired stimulative effects, it will likely reduce overall economic productivity by diverting capital from the private sector. It’s QE that matters, and given how large sovereign debt markets are today, there’s no need for more deficits in order to conduct more QE.
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