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Spending, Money, and Time, Part 2

December 21, 2011

In my previous article, I discussed how there are two sides to every macroeconomic story: real and nominal. I also discussed how difficult it is to move consumption in aggregate and how you cannot consume what has not yet been produced. In this article, I will cover the nominal side and go over some potential objections to my previous claims.

Government Debt, Taxation and Spending
Imagine a world where the government spent 10% of GDP, and taxed 15% of all consumption, no exceptions. The difference between what it took in and what it spent was buried in an underground vault. There is no central bank. How much of the economy would be private consumption and investment? What would happen to prices?

If private consumption and investment is reduced by taxation, private activity would be 85% of GDP, but if you add 10% to 85%, you only get 95%. What would happen to the remaining real capacity for production? If it was idle, its price would fall until someone bought it and put it to good use. If the answer is 90%, you get to 100% of the economy, but what happens to the additional 5% of the money? As Hume pointed out: “If the coin is locked up in chests, it is the same thing with regard to prices, as if it were annihilated.” Thus, assuming constant velocity of money, prices will fall by 5% every year. It is government spending, not taxation, which reduces private real consumption and investment. Spending uses up scarce productive resources; taxation does not.

Taxation is a way of reducing the money supply, and hence reducing nominal spending. The reason you tax is not to provide funding for the government, which can print however much money it wants to spend. The government taxes to reduce the inflationary effects of spending. If you reverse our example above, prices would increase by 5% each year as the government financed its spending by printing another 5% of the money supply to fund its spending.

Why Bonds and not Currency?
Our current government does not print money to fund its spending. It sells bonds and uses the proceeds to fund its spending. The central bank then determines the ratio of bonds to currency. Bonds yield interest, which means they are worth more tomorrow than they are today (at least in nominal terms). They are also harder to use as a medium of exchange. Stores are unlikely to accept government bonds as payment, although most banks would. Because of their yield, the velocity of bonds is lower than the velocity of high powered money. People are less likely to increase their current spending if given a bond than if they are given cash, so the inflationary impact of issuing bonds is lower than the inflationary impact of issuing currency.

By affecting the amount of currency and bonds, the central bank is able to control inflation under most circumstances. Expectations matter, and bonds also carry a promise by the government to tax more in the future to either repay them or at the least, pay the interest on them. The higher expected future taxation lowers expected future inflation. High inflation should be avoided because it causes large deadweight losses compared to other forms of taxation.

Flexible prices and Monetary Disequilibrium
Throughout my previous analysis, I have assumed flexible prices, which implies that if the rate of spending drops, prices fall and all factors are still used to their full potential. If some prices are sticky, they will be too high when the rate of spending decreases and too low when the rate of spending increases unexpectedly. These relative price shifts will result in inefficient allocations of resources, and in the case of sticky wages and decreases in spending, unemployment above the natural rate. I believe the central bank should aim to stabilize the level of spending, or at least make the rate of spending predictable enough that entrepreneurs and households can plan their economic activities to compensate. Perfect monetary policy means the Real Business Cycle Theory (the theory that real shocks cause recessions) is 100% true, because if nominal shocks are eliminated, only real shocks remain.

Trade
My previous analysis seems to be of a closed economy, but making the model open does little to alter its conclusions. The biggest source of confusion when discussing trade is that the trade deficit is a type of debt. Every trade, international or not, reflects an exchange of goods. If two groups are trading, the first group will only trade if what they gets by the trade is more valuable to them than what they give up, and vice versa. Every single trade reflects a mutually beneficial exchange of goods of approximately equal value.

The trade deficit arrises when people trade goods for claims on capital and currency. If a foreigner invests in an American firm or buys American capital, the value of that transaction is added to the trade deficit. Americans get goods in exchange for capital, and no debt is accrued to either party. Furthermore, circles of trade could develop, where Country A sells to Country B, who sells to Country C, who sells to Country A. Each country’s trade deficit with each other would spiral toward infinity, even though no one owes anyone anything. If one country accumulates a large amount of a foreign country’s money, they can command a high proportion of that country’s exports in the future, but they cannot force a country into bankruptcy.

Conclusion
One person’s spending limits another persons spending now by using up resources, no matter whether that spending is funded by debt, taxation, or whatever. Debt reduces future production by increasing taxation, and thus deadweight losses. Its main effect is to reallocate the gains from production from debtors to creditors (if it is paid back).

(This is my 100th post! Huzzah!)

Further reading:
Paul Krugman on debt.
Karl Smith comments.
Nick Rowe comments.

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