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What would happen if the commies actually had influence in the everyday affairs of the current administration. No, seriously. As profligate as the last two Admins have been, I do not think they have crossed this line, at least not yet. Let’s address one of the points made in that “article.”

Myth #1: The government should balance its books like a private household.
Reality: Our federal government is the issuer of the currency, which makes its budget fundamentally different than the average citizen’s.
Discussion of government budget deficits often begins with an analogy to a household’s budget. People say: “No household can continually spend more than its income, and neither can the federal government”. But there are big differences between a household and the federal government. You don’t have the ability to print money in your living room, do you? Well, the government does. So how it finances its own debt and spending is different from the way you do.

A government is the issuer of the currency. The household, on the other hand, is the user. Households are restricted by the need to somehow get money into their bank accounts, or their checks will bounce. The federal government, by contrast, doesn’t “have” or “not have” dollars. There is no vault or lock box where it “keeps” its money. In fact, it makes all of its payments simply by electronically crediting private bank accounts and there is no practical limit to which it can change those numbers up. Spending by the federal government always creates new money in the system, while taxation destroys it. When households and firms pay taxes, the money does not go anywhere; the government simply debits those private bank accounts by electronically reducing the amount of reserves they hold, i.e., by changing the numbers in those bank accounts down.

Government is constrained only by the inflation it can create by over-spending, but its ability to spend is numerically unlimited. Households are constrained by their ability to get dollars from some form income and from borrowing, and both of those have real limits.

~Pavlina R. Tcherneva, Assistant Professor, Franklin and Marshall College

Well, take Franklin and Marshall off the list of schools my kid will be thinking about attending. Now, I’m not of the belief that government needs to balance its books – that is nonsense. Lots of time, debt makes sense. Particularly if you expect to be richer in the future (that would have been unthinkable for generations living 200 years ago, hence less debt back then (at least one reason)), then incurring debt today can very well be prudent. What I do have a problem with is running a balanced budget while spending 50% of GDP on government. That is not only a serious violation of my property rights (as if small violations are any less of a violation) but it is a serious drain on economic growth. I’d much favor a world where we ran infinite budget deficits but that spending was only 5% of GDP. Our dear professor doesn’t say much about these differences.

But more to the point, what she is saying is that technically, the US can be Zimbabwe, so the issue of budget deficits is overblown. I don’t even need to say more than that, but let’s see exactly what kind of inflation we would have to deal with in order to “solve” our current debt “crisis.” By the way, if we solved it, that would just clean the slate for another spending orgy to be solved by our kids … so I am not entirely sure I favor solving any of the current problems either (sort of like learning that someone invented low-cal donuts, you may end up fatter in that world than in a world with high cal donuts).

Anyway, regardless of your beliefs about whether the money market is in equilibrium or not, this equation, which is an identity, is a useful way to think about money market dynamics. Milton Friedman’s license plate in fact had it printed on it. What did it say?

MV = Py

That is known as the “Equation of Exchange.” All it is saying is that the amount of money in an economy is equal to a fraction of the amount of income in an economy. If people like to hold a large share of their income as money (as opposed to other financial or other assets), then the amount of money in circulation will be large as compared to the amount of goods and services produced in an entire year (V stands for “velocity” where velocity is a convoluted way to write the inverse of people’s interest in holding money balances as a share of their total income, so V would be low here). If people like to hold a small share of their income as money, then the amount of money in the economy would be small (V is large).

Now, let’s think about the implications of Dr. Tcherneva’s worldview. Right now, the U.S. government is expected to run annual deficits of $1.5 trillion. Let us examine the economics of this view from two perspectives. First, let us ask what would happen to inflation if the government turned into Greece and was unable to borrow any money to finance beyond its spending (that assumes we can still tax to the tune of $2.5 trillion per year, hardly a realistic assumption). As of this writing, M2 is about $8.5 trillion while M1 is about $1.7 trillion. The actual amount of purchasing media in the economy is likely somewhere in between. For argument’s sake, let’s call it $4 trillion.

If we write the equation of exchange in growth form, it becomes this:

The percentage change in M + the percentage change in V = The percentage change in P + the percentage change in Y

Rearranging and reinterpreting, you would see that:

The rate of inflation = the increase in the money supply + the change in people’s preferences for holding money – the real rate of economic growth (p = m + v – y)

So, to monetize all of the current year’s excessive spending (and each year for the infinite future) we would be creating some inflation. How much? Let us make some assumptions, each of them generous. Let us assume that people’s money holding preferences do not change over time.  If you believe that as a country enters into an inflationary period that people would wish to hold less and less of that country’s money, then the rate of change of V, what I call v, would be positive (in other words, the share of our income we hold as money would fall, and since V is the inverse of that, V would rise). Similarly, let us make the very generous assumption that real economic growth would be 3% per year, for every year going forward. Note that the US has rarely sustained that level of growth (and funnily enough, the Obama Administration is assuming larger growth numbers than that in order to say he would reduce the primary budget deficit after he is re-elected). Adding $1.5 trillion to the money stock each year, when the current money stock is $4 trillion, would appear to be a 37.5% increase in M (so little m is 37.5%). That number is larger if you think M1 is a more appropriate measure of money and that number is smaller if you think M2 is a more appropriate measure of money. What would happen to prices each year in this world?

p = 37.5% + 0% – 3%

p = 34.5%

In other words, if the Administration wants to keep up its spending party and monetize it each year, then we would see annual inflation of 34.5%. While that is not Zimbabwe level inflation, it is far more serious than any inflation level we have ever seen. Savings would be devastated. The poor would be devastated. Retirees on fixed incomes would be devastated.

Second, let us examine what would have to happen for the United States to pay for all of its accumulated deficits – in other words, if it had to deliver on its entire existing national debt, PLUS the entire amount is owes via unfunded entitlement programs (Medicare, Social Security, Public Sector Pensions). Estimates of its outstanding obligations range from $50 trillion to $100 trillion. I’ll be kind and say it is only $50 trillion. In other words, that is the total amount of money we need to come up with in order to pay everybody the goodies that we promised them. And again, since Dr. Tcherneva’s seems to think we can just print up some dollars to pay for this, let us think about the implications. We could try to pay it all off in one year. But that would be extremely hard to do. Or, we could try to form a “5 year plan” or probably something like a 20 year plan to pay it all off. If we make the assumption (heroic) that nothing would be added to these debt obligations over 20 years, then on top of financing the $1.5 trillion in annual government budget deficits, we would have to “pay off” $2.5 trillion more each year to take care of those nasty little unfunded liabilities (or $5 trillion if you price those obligations more realistically). Returning to our equation of exchange, we would be printing an additional $4 trillion of money, on top of the existing $4 trillion. So money growth would be 100% (in the first year … the money growth rate would be smaller each year, but then again, y would fall and v would increase, so I simply hold them constant for now). Our dynamic equation of exchange would suggest we’d face inflation rates not 2% per year as we have seen for the last 30 years, and not even 34.5% like we would see if we simply monetized our deficits each year, but we’d see 100% + 0% – 3% = 97% increase in the level of prices each year. In other words, we could “pay off” all of our debts if prices doubled every single year.

So, Dr. Tcherneva’s is certainly correct that technically it is possible to print lots of money. But in the real world, that is like saying, “technically, it is possible for Rizzo to safely strap himself to a rocket and fly around the earth and land back where he started, safely …”

In a future post, we will examine would 97% annual price level increases would do to an economy – and who would benefit and who would lose.

2 Responses to “That Pesky Little Equation of Exchange”

  1. Kevin Lin says:

    Wow, that article made me laugh.

    Come to think of it, I could really do with just “digitally adding” a “10” in front of the current number my current bank account… since it doesn’t harm anyone it would only do wonders, would it not?

  2. Harry says:

    During the inflation of the ’70’s, Robert Bartley said, I think correctly, that it would be wrong to be obsessed with debt and deficits to the point where government used that as an excuse to raise tax rates, in particular if that meant reducing saving and investment.

    After all, when the government, or any private concern spends on something that is durable and is also useful, like a bridge, or a mill, it may, perhaps, make sense to finance it with debt over it’s useful life.

    Therefore one need not pay cash for the bridge or the mill, assuming the cost of the loan is offset by a more productive use of the cash elsewhere.

    This is very different from the Keynsean notion of “Well, we are just borrowing it from ourselves.”

    If the government overborrows too much, the political reality is that it will solve it’s problem not just with taxation, but also by printing money and thereby debasing the currency.

    Thus, we are not “just borrowing from ourselves” but robbing people of their property, who happen not to be “Us” but

    The sick part is that all along we all know who they and we are.

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