I doubt that more than one percent of politicians understand the deficit and the national debt. The reason is that they have not grasped the distinction between microeconomics and macroeconomics.
When a microeconomic entity, e.g. a household or firm, runs a deficit, we all know the cure: its income must be increased and/or its spending reduced. Unfortunately politicians, and (sad to say) most economics commentators, extend this thinking to macroeconomic entities, like entire countries or governments. For example they claim that cutting public spending will reduce the deficit. Well it will, but the result is also more unemployment. So that is more a case of “out of the frying pan and into the fire” than a “cure”.
Macroeconomics is a different world to microeconomics. Here is a question that illustrates the difference. Suppose a government wants to increase spending by ten billion, how much extra tax should it collect or how much extra should it borrow? Well the answer is most certainly not ten billion. The answer could be far less than ten billion or far more.
What such a government does need to do is to ensure that the stimulatory effect of the extra spending is cancelled out by the deflationary or “anti-stimulatory” effect of extra tax. And gauging those effects is not easy.
At any rate, bearing in mind that it is the above sort of effects that are paramount in macroeconomics, I’ll try to show that printing money and buying back the national debt is, at least in principle, easily done.
Several countries have already printed a fair amount of money and bought back national debt under the guise of Quantitative Easing, and this has been a bit of a non-event. The effect on demand has not been spectacular. So can QE be taken further: that is could we print money and buy back large portions of the debt, with similarly little by way of effect – in particular little effect on inflation?
Well the consensus seems to be that QE has been mildly stimulatory. Thus QE done big time would doubtless be too stimulatory, and thus too inflationary. But that is not a problem because the inflationary effect can always be nullified extra tax (or reduced public spending): in particular by the deflationary effect of those tax/spending changes. And if the deflationary effect exactly cancelled out the above inflationary effect, there would be no net effect. That is, there would be no effect on aggregate demand, numbers employed, average take home pay, and so on. (Incidentally I am using the word deflation here in the “demand reducing” sense, rather than in the “price reducing” sense.)
As to the exact amount of additional tax needed to counter the inflationary effect of buying back a large portion of the national debt, that is a difficult technical question, which I will not address here. My hunch is that the amount of additional tax would be a small proportion, say about a tenth, of the amount bought back.
But the important point is that in principle whatever the inflationary effect of a buy-back, it can be countered with extra tax and/or reduced public spending. Of course the net effect of the buy-back does not absolutely have to be zero. One could collect insufficient tax, which would mean the buy-back would be stimulatory. But for simplicity, I’ll stick with the “zero stimulus” assumption.
So why don’t we go for it: print a few trillion of new money and just buy back the national debt?
Keynes and Roosevelt
This buy-back proposal very much ties in with a point made by Keynes. Keynes said (e.g. in a letter to Roosevelt in the 1930s) that stimulus can come from extra government spending financed either by borrowing or simply by printing money. (See 5th paragraph of Keynes’s letter.)
http://www.scribd.com/doc/33886843/Keynes-NYT-Dec-31-1933
Now if Keynes was right there, it follows that if a country has recently effected stimulus via the borrowing route, it should be possible to switch, after the event, to the “print money” route. That is, it should be possible to turn portions of national debt into monetary base without too much of a problem. (Incidentally, Ellen Brown advocates very much this sort of solution to the supposedly insoluble debt problem in Chapter 39 of her book “The Web of Debt”. The chapter is aptly entitled “Liquidating the Federal Debt Without Causing Inflation”.)
Debt held by foreign entities.
Another potential, but not serious problem relates to debt held by foreign entities (foreign governments, institutions, individuals, etc). Clearly where debt held by such entities is bought back, a portion of the newly acquired cash in the hands of those entities will leave the country, which would depress the value of the relevant country’s currency on foreign exchange markets, which in turn would depress living standards in the country concerned. However there are several answers to this problem.
First, the decline in living standards is unlikely to be dramatic. The pound sterling lost about 25% of its value in 2008. The result has not been Greek style riots in the UK. Moreover the loss in UK living standards has been small compared to the loss suffered by European periphery countries as a result of their economic mismanagement (or if you like, as a result of the inherent problems of the Euro).
Second, where just one country did a buy-back, its currency would certainly lose value. But if several of the larger countries with allegedly excessive national debts all bought back simultaneously, those countries’ creditors would have almost nowhere to go. Thus nothing dramatic would happen on foreign exchange markets.
Indeed the above foreign exchange problem is not a problem unique to the buy-back proposal. That is, ANY country which does ANYTHING significantly different to the rest of the world is asking for trouble. For example if one country raises its interest rates when the rest of the world is cutting rates, that country will have problems. Thus a fair appraisal of the buy-back should involve gauging the effects when a significant proportion of the world’s economies implement the buy-back simultaneously.
Money supply has been increased
Another apparent problem is that if the amount of tax needed to counteract the inflationary effect of the buy-back is small, the result will be a dramatic increase in the monetary base, which in the long term could prove inflationary.
The answer to this is that it is generally accepted that in a recession, it is desirable for governments to run deficits, which result in a faster than normal increase in the national debt. And come the recovery, it is generally accepted that the debt can be paid back, or at the very least, it can stop growing.
Now remember that Keynes in his letter to Roosevelt said that it does not matter too much whether a deficit is funded by new money or borrowing. Thus if a country goes for the “new money” option, then much the same applies to the monetary base as applies to national debt. That is, in a recession, the monetary base will grow faster than usual, and come the recovery, this new money can be withdrawn (via extra tax), or at the very least, the growth in the monetary base can be stopped.
Does a buy-back really make sense?
The initial reason for the buy-back given above was simply that the world at large is panic stricken about the size of national debts. And that is not a brilliant reason. However, there is a better reason as follows.
As already mentioned, Keynes claimed that stimulus can be funded either via borrowed or printed money. Now borrowing has a deflationary effect, that is, it is anti-stimulatory! So what is the point of borrowing? Frankly I don’t know.
However I get the impression that Keynes regarded himself as being surrounded by economic illiterates who thought that printing money invariably and necessarily resulted in instant hyperinflation. So to keep this lot happy, he advocated borrowing as an alternative: an alternative which he himself did not strongly favour.
The only problems are political
To summarise, there are no strictly economic problems involved in reducing national debts: debtor countries can simply print extra money and buy back the debt. Obviously buying back a country’s entire debt in just one year would involve too much dislocation. But doing it over a five or ten year period would be no problem.
The only real problems are political. That is a buy-back, while it need not involve any change in living standards, certainly would involve increased taxation and/or reduced public spending. And whichever sections of the population faced additional tax, they can be relied on to object. In fact they can be relied on to jump up and down with contrived indignation the likes of which you’d think only a Hollywood actor could manage.
And finally, some readers may still be puzzled by the idea that extra tax will not reduce living standards. The explanation, of course, is that the typical employer would see additional demand from customers as a result of the above money supply increase. That effect, if not countered, would result in extra profits and/or higher wages, and/or extra output and so on. So assuming constant GDP is the objective, the effect of the money supply increase has to countered by extra tax on profits, wages, and so on.
