Deficits do matter, but not how you think, economist says

Stephanie Kelton has been busy educating financial advisers about how money works. That may seem like an odd task, but Ms. Kelton, who heads the economics department at the University of Missouri-Kansas City, is one of the most outspoken proponents of what is known as modern monetary theory. MMT's followers think that, far from being a bad thing, government deficits are actually critical in financing private-sector growth. Their theory holds that the government's balance is the mirror image of non-government balances — when one is in deficit, the other has to be in surplus. Few people realize this basic accounting fact, according to Ms. Kelton. Contrary to popular belief, government surpluses drain resources from the private sector and inhibit growth, she said. Ms. Kelton has been taking her message to planners around the country — speaking at the Financial Planning Association's national conference last year, and more recently at a dozen or so FPA chapter meetings. “She's challenging the way we think,” said Martin Kurtz, founder of The Planning Center Inc. and past president of the FPA. Planners “are people who spend a lot of time thinking about money and finance, but not in the way that I think about it, so it is a fun conversation,” Ms. Kelton said. Misunderstandings about money lead to bad forecasts, she says. MMT predicted that Japan, the U.S., and the U.K. would continue to be able to borrow at low rates despite growing budget deficits because they control their own money, unlike countries that use the euro. Ms. Kelton recently discussed MMT with InvesmentNews in the context of the raucous debate in Washington over spending and taxes. InvestmentNews: Are MMT theorists saying deficits don't matter? Ms. Kelton: Deficits do matter, but not in the way people think. If you look at any country in the world and do a sector financial balance analysis that breaks the economy into domestic private sector balances, government balances and foreign balances, inflows to one are outflows from another. It's a balance sheet analysis and the net flows have to add to zero. This is fundamental to the MMT framework, and it's important because you can then see that with the U.S.'s persistent trade deficit, dollars flow out, which means the domestic private sector is losing financial assets to the rest of the world. Unless the government sector offsets that flow with its own assets, it will leave the private sector in the hole. That's exactly what happened in the Clinton years. Clinton ran a budget surplus. So the private sector got absolutely hammered. It drove itself deeper and deeper into debt to finance itself. InvestmentNews: So the Clinton surpluses helped cause the financial crisis by forcing the private sector to lever up? Ms. Kelton: Exactly. One of the most famous and accurate forecasters in Britain, Wynne Godly, who later came to the U.S. and the Levy Economics Institute [of Bard College], wrote about this. The Congressional Budget Office was saying the surpluses were fantastic and that the government would be able to pay off its debt. Godly said this was nuts, that it can't happen because he understood sector balances. The CBO's mistake was in failing to understand that persistent government surpluses could only be achieved if the private sector did what it had never been done before — spend more than its income for decades on end. InvestmentNews: Does the federal government ever need to cut its deficit? Ms. Kelton: The private sector should decide that. The public sector is the partner in the dance. The government should let the private sector lead. When the private sector wants to increase its holding of dollars and net financial assets, by spending less and saving more, the only way that can happen is for another sector to spend more than its income. If the government doesn't play ball and run a deficit, it will cause a recession. The proper role of government is to be responsive. When there's an increased private appetite, you accommodate that by running a deficit. It's irresponsible not to. The deficit will come down by itself. I don't think policy makers should actively manage the deficit. Right now, the deficit is falling at the fastest rate since World War II. No one talks about that. While the folks in Washington are falling all over themselves to come up with a plan to cut the deficit, it is quietly plummeting at its fastest pace in two generations because the economy has been adding jobs. Deficits rise when unemployment rises and they fall when unemployment falls. InvestmentNews: What about entitlement spending, which is projected add to the deficit because of demographic changes? Ms. Kelton: A lot of people say that the biggest driver is healthcare spending, and they cite the Congressional Budget Office. But the CBO's record is not terribly good. You can't look at healthcare costs for the last 40 years and project those costs forward. Already, those projections have gone down to about 4% growth from 9%. And we may see more decelerations. I'm not sold on this idea that we'll be spending something like 40% of GDP on healthcare — that's ludicrous. It's one of those things that can't happen, so it won't happen. I'm not saying you can't change entitlement programs, but the cost overruns are based on 40- and 70-year projections. I see little reason to make any adjustment today, based on very tenuous forecasts. InvestmentNews: When interest rates go up, won't paying interest on the national debt become a huge burden? Ms. Kelton: We always say it's not the ratio of debt to GDP, it's the debt service. You can have a rising ratio, but falling debt service. You don't want rates rising faster than the rate of growth in the economy. So for debt to be sustainable, if you can muster any positive growth — and as long as you have your own currency — the central bank can always maintain lower rates when the economy is growing. InvestmentNews: With deficits and loose monetary policy, isn't there a big risk of inflation from too much money chasing too few goods? Ms. Kelton: Resource constraints are real. If your economic policies are too aggressive, you will end up competing with the private sector for these recourses. The result will be inflation. But we almost never have this kind of inflation in the U.S. economy because we rarely operate our economy at full employment. Even operating the economy at full employment as we did in the late 1990s and early 2000s is not necessarily inflationary. As long as productivity growth is high, you don't end up with "too few goods" so you don't get the inflationary pressure. The overriding driver of inflation, both in the U.S. and around the world, is the price of oil. The evidence of that is overwhelming. Regarding quantitative easing, the Federal Reserve takes bonds off bank balance sheets and replaces them with a credit to the bank's reserve account at the Fed. We said it's an asset swap, nothing more. We predicted it would not lead to inflation and large bank reserves, and to more bank loans. It is optimism from borrowers and optimism from banks that drives lending. And there's no reason the Fed has to unwind its balance sheet. The Fed can slow lending by paying interest on reserves. If the bank doesn't think it can do better by making a loan, it will just sit on the reserves and earn the rate the Fed pays. Central banks are concerned with the optics of giving money to banks, but they've said themselves there are no economic problems in paying higher rates on reserves. InvestmentNews: Do you think advisers make investment mistakes because they don't understand how money works? Ms. Kelton: Absolutely. For example, you won't make mistakes when you understand the differences between the risks associated with lending to an issuer of a currency versus to the user of a currency. Lending to the U.K. instead of eurozone countries, for example. Japan, Canada and Australia are also in a completely different boat, because they issue their own currencies. So you've seen [hedge fund manager] Kyle Bass betting against Japan and Bill Gross betting against U.S. Treasuries and missing badly. They didn't understand the difference between being an issuer of a currency and being a user who has to borrow it.