The Deficit and the Money Supply

As the New Year begins, many writers are looking back on the events of 2009.  Many are focused on the impact of the bailout and stimulus programs on the U.S. economy.   While some credit those programs with ending the U.S. recession, others worry about the resulting deficit and the ability of the government to sustain this level of spending into the future. 

I, for one, believe that the economy would have been better off without the bailouts and the stimulus program.  But proving that claim is a difficult task, not just for me, but for anyone trying to address the question.  

I have a research project under way that I hope will lead to a better measure of the impact of government spending on GDP, but it will be some time before those results are in.  In the meanwhile, I want to help to clarify some economic issues that underlie much of the debate about the stimulus and the deficit.

First of all, the deficit is defined for the fiscal year only.  It is a one-period measure.  The deficit for 2009, for example, is total 2009 government spending (including interest on debt, which is the cumulated book value of deficits) minus total 2009 government "revenues."   Government revenues consist of taxes plus the proceeds from asset sales (http://www.govsales.gov/HTML/INDEX.HTM). 

Second, the U.S. deficit is our trading partners' surplus.  Our borrowing is their lending.  There is nothing inherently wrong or weak about the U.S. running a deficit, or selling Treasury bills or bonds to finance spending.   

Typically, the Treasury avoids using the Federal Reserve's balance sheet for its tax collecting and check writing activities, expressly to avoid tainting Monetary Policy with Fiscal Policy, or "monetizing the debt."  Of late, however, under Geithner's leadership and Bernake's followership, that distinction may be blurred beyond recognition.  The current level of the money supply, given fairly stable reserve requirements and discount window policy, is largely determined by open market operations (OMOs), or the purchase (or sale) of newly issued Treasury bills and bonds with newly created Fed reserves; i.e., the famous "the Fed creates money with the stroke of a pen" or, these days,"with a click on the keyboard."

Pre-Geithner, the Fed created money strictly through OMOs and changes in reserve requirements and discount window activities, with the goal of supporting GDP with the appropriate interest rate target without excessive inflation. Now, it's worrisome how much policy independence the Fed seems to have retained.  In a real economy crisis with rampant unemployment, should the Fed "do something?" And what if those actions exacerbate inflation? Now what is our policy priority:  lowering unemployment or lowering inflaton?

No easy task here: find just the right level of money supply growth that will find the right level of short term interest rates without over- or under-stimulating inflation.

Comments

[Jeff Greenwald]

Does the massive debt purchased by the Chinese prevent them from properly valuing their currency? If they let their currency rise in value (or let the market set the rate) they would then devalue their debt holdings. Seems like good news for consumers (i.e. continued cheap goods from China) but bad news for exporters.

[Sherry Jarrell]

Good question. You'll have to let me know if my answer makes sense, because it touches on many different issues.

The relative value of a currency depends first on the productive capacity of its economy and second on the relative world supply and demand of that currency. Taking the productive capacity as given, China must use its yuan to purchase the dollars it needs to purchase U.S. dollar-denominated debt. This represents a relative increase in the world supply of yuan in circulation. As the world supply of a currency increases, it depreciates, and all goods denominated in that currency fall in price as well.

But there isn't necessarily a perfect correlation between the Chinese purchase of U.S. debt and the supply of Chinese currency, because the Chinese government, like the U.S. government, can purchase assets without creating new money by issuing its own debt or selling assets.

Further, it isn't entirely clear whether China is currently pegging the yuan to the dollar or not. A few years back they officially ended their fixed exchange rate policy, but recently have undertaken actions that make it appear they are once again pegging the dollar, if unofficially. If they are pegging the yuan to the dollar, as the yuan is pressured down, the Chinese government would take measures to decrease the world supply of yuan to prop up its value.

Finally, the value of the yuan in the world economy also depends on the supply and demand of the dollar, and on the relative rates of inflation between trading partners.

I don't know whether this prevents them from "properly" valuing their currency. I'm not sure we know what the "proper" value is.

Does that somewhat address your question?

[Jeff Greenwald]

I often see a lot of articles like this:

http://www.bloggingstocks.com/2008/01/07/china-learned-that-yuan-dollar-peg-is-a-two-edged-sword/

That mention the Yuan being artificially low so China can boost their exports and keep the economy growing at a fast rate - which keeps their population employed and happy (and not protesting).

So if true and the Chinese stopped artificially keeping their currency low, when it rose their dollar debt assets would lose value relatively and their exports would be more expensive (slowing growth). I have heard that they woudl really like the dollar to be strong so their debt assets don't decrease in value. Apparently this is a political issue for them now with over a trillion $ in US debt holdings.

Makes me wonder if China is not dependent on having a "weak" currency like we are dependent on having countries like China around to buy up our debt.

[Sherry Jarrell]

I think you have it about right. Countries in the world economy are definitely interdependent and every advantage to a weak currency has an offsetting disadvantage in some other part of the economy. I think that what is rumbling around underneath of this coverage of exchange rates and China and US debt is the productivity of the real economy -- capital and labor and managerial skill. That is what drives the real interest rate and that is what increases the demand -- foreign or domestic -- for an economy's debt instruments: its ability to repay what it borrows with a healthy real interest rate.

When an economy, like China, pegs its currency, it generally loses control of its monetary policy. That is the case here although exacerbated by China's decision to keep their currency depreciated, which requires a constant increasing supply of yuan. The article you site actually has the causality surrounding this issue backwards:

"... On the other hand, China is learning that when you tie your currency to the dollar, if the dollar depreciates, the price of everything you buy increases," Wang said. "And that's feeding China's inflation, and making it hard for government officials to contain it."

Notice that this quote is saying that it is the appreciation of the yuan relative to the falling dollar that is causing inflation. It is the other way around; the increase in the supply of yuan is causing inflation which in turn is causing the yuan to depreciate in real purchasing power.