November 6, 2017

On the saying “We owe the debt to ourselves”

Own post, no external Blog-Reference

The best-known meme of Functional Finance and MMT with regard to internal public debt is “We owe it to ourselves” which is to say that there is nothing at all to worry about.

The growth of public debt is usually discussed within the Walrasian or the Keynesian framework. The problem is that both the microfoundations approach and the macrofoundations approach are axiomatically false. Methodologically it holds: if the axioms are inconsistent the whole analytical superstructure falls apart. Because of this, it is necessary to shift to the correct macrofoundations and to rethink the whole issue of public deficits/debt.#1

As the correct analytical starting point, the elementary production-consumption economy is defined with this set of macro axioms: (A0) The objectively given and most elementary configuration of the economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm. (A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L, (A2) O=RL output O is equal to productivity R times working hours L, (A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.

Under the conditions of market-clearing X=O and budget-balancing C=Yw, the price is given by P=C/X=W/R, i.e. the market-clearing price is in the initial period equal to unit wage costs. This is the most elementary form of the macroeconomic Law of Supply and Demand. For the graphical representation see Figure 1.#2

Monetary profit for the economy as a whole is defined as Qm≡C−Yw and monetary saving as Sm≡Yw−C. It holds Qm≡−Sm, in other words, the business sector’s surplus = profit (deficit = loss) equals the household sector’s deficit = dissaving (surplus = saving). This is the most elementary form of the macroeconomic Profit Law. Under the condition of budget balancing, total monetary profit is zero.

There are three alternatives of how to redistribute output between the household and the government sector: (i) taxation, (ii) public deficit spending and compensatory household sector saving, (iii) public deficit spending with newly created money.

(i) The government needs, for some legitimate reason, a part of the output in period 1 and decides to tax the wage income receivers. Wage income is unchanged Yw1=Yw and disposable income is then Yw1−T1. The consumption expenditures of the household sector fall by the same amount under the condition of budget balancing, i.e. Ch1=Yw1−T1. Taken together, total expenditures of the household and government sector remain unchanged, i.e. Ch1+Cg1=C. The government sector’s budget is balanced, i.e. Cg1=T1. Accordingly, one has these three sectoral balances.

Qm1≡Ch1+Cg1−Yw   monetary profit/loss, business sector,
Sm1≡Yw−T1−Ch1     monetary saving/dissaving, household sector,
Bm1≡T1−Cg1           surplus/deficit, government sector,
Qm1+Sm1+Bm1=0 with Qm1=0, Sm1=0, Bm1=0.

The market-clearing price remains unchanged, i.e. P1=P=W/R. The real share of the household sector is Oh1=Ch1/P1 and of the government sector Og1=Cg1/P1 with Oh1+Og1=O1=O.

Thus, the transfer of a share of current output from the household to the government sector is completed. In the following periods, government taxation and spending are again zero. Everything is as it was in the initial period.

(ii) The government needs again a part of the current output but does not tax the wage income receivers. Instead, a group A of the households saves, thus that household sector saving Sm1≡Yw1−Ch1 is exactly equal to government spending, i.e. Sm1=Cg1. Total expenditures remain unchanged, i.e. C1=Ch1+Cg1=C. The real shares of output are exactly equal to the taxation variant (i). The balances now look as follows.

Qm1≡Ch1+Cg1−Yw   monetary profit,
Sm1≡Yw−Ch1          monetary saving,
Bm1≡−Cg1              government sector deficit,
Qm1+Sm1+Bm1=0 with Qm1=0, Sm1>0, Bm1<0.

The public debt (= stock) has been zero and is at the end of the first period equal to the deficit Cg1. It may accumulate in subsequent periods or not. The household sector’s savings (= stock) have been zero and are at the end of the first period equal to Sm1. Both amounts are exactly equal and it is assumed that the government debt is fully consolidated by selling bonds to group A of the households = savers = creditors.

All households are taxed beginning with period 2, thus that the total of lump-sum individual tax is equal to the total of interest payments that go to the creditor households A. As a result, the disposable income of the creditor households increases and that of the complementary group B decreases. So, for the duration of the debt, an income redistribution takes place. It is NOT the case that “we” pay interest to “ourselves” but group A + B = “we” pay to group A = creditor households. The net income increase of group A is interest minus lump-sum tax of group A. Compared to the taxation case (i) group A is better off and group B is worse off depending on the interest rate and the duration of the debt.

Eventually, the public debt is redeemed. All households A+B are taxed in period t and the sum goes to the creditor households A. The tax in period t, i.e. Tt, is equal to the public debt Cg1. The households spend their current income, i.e. Ct=Ywt, the lump-sum tax is paid by dissaving. The balances now look as follows.

Qmt≡Cht−Yw       monetary profit, Cht=Yw,
Smt≡Yw−Tt−Cht   monetary dissaving, Smt=−Tt,
Bmt≡Tt               government budget surplus,
Qmt+Smt+Bmt=0 with Qmt=0, Smt<0, Bmt>0.

At the end of period t, the public debt is again zero. The household sector as a whole ends up with total savings of zero which are composed of deposits of group A and overdrafts of group B. The public debt becomes in part private debt = overdrafts at the central bank after the completion of the whole cycle. Group A can pay the tax out of savings and is left with deposits at the central bank. Group B is left with overdrafts of an equal amount.

So, public deficit spending plus compensatory household sector saving amounts to a deferred tax for the household sector as a whole. Instead of paying the tax in period 1, the household sector pays in period t. For the duration of the tax deferment, a redistribution of income from all taxpayers A+B to creditor households A takes place. The statement “We owe the debt to ourselves” is misleading. “We”, i.e. A+B, owe the debt to A. Compared to taxation (i) deficit spending (ii) makes group B worse off. In addition, group B is left with private debt at the end of the process.

Only if all households A+B save the same amount and are taxed the same amount the whole process is distributionally neutral.

(iii) The government again runs a budget deficit. Now, the households do not save but spend the whole period income Ch1=Yw1=Yw. Government spending is given with Cg1 and taxes T1 is zero. Total expenditures are now C1=Ch1+Cg1 and this yields a price hike: P1=C1/X=(Ch1+Cg1)/X=P+Cg1/X with market-clearing X=O.

The redistribution of output between the household sector and the government sector, that is, the REAL taxation, is now realized via the price mechanism and becomes thereby invisible. If deficit spending is exactly repeated period after period the price remains at the elevated level, otherwise, it falls back to the initial level. The balances now look as follows.

Qm1≡Ch1+Cg1−Yw    monetary profit, Ch1=Yw, Qm1=Cg1,
Sm1≡Yw−Ch1           monetary saving,
Bm1≡−Cg1               government budget deficit,
Qm1+Sm1+Bm1=0 with Qm1>0, Sm1=0, Bm1<0.

The amount Cg1 = government budget deficit comes from the central bank, i.e. is created out of nothing. The two sides of the central bank’s balance sheet, overdrafts, and deposits, rise by the same amount. The newly created money ends in the ‘cash box’ of the business sector, i.e. government sector’s overdrafts = business sector’s deposits. It is assumed that the government consolidates its overdrafts by selling bonds to the business sector. So overdrafts and deposits at the central bank vanish completely.

The household sector is then taxed with a lump-sum tax and the interest payments go to the business sector for the duration of the public debt. There is no redistribution of income between different groups within the household sector. The creditor is now the business sector.#3

Eventually, the public debt is redeemed. All households are taxed in period t and the total of the lump-sum tax, Tt=Cg1, goes to the business sector. The tax reduces current spending Cht<Yw. This causes the market-clearing price to fall. The balances now look as follows.

Qmt≡Cht−Yw         monetary loss, Cht<Yw,
Smt≡Yw−Tt−Cht     monetary saving, Tt+Cht=Yw, Smt=0,
Bmt≡Tt                 government budget surplus,
Qmt+Smt+Bmt=0 with Qmt<0, Smt=0, Bmt>0.

Monetary loss for the economy as a whole is now given by Qmt=Cht−Yw=−Tt. The loss in period t is exactly equal to the profit of period 1. Deficit spending again amounts to a tax deferment for the household sector. The difference to variant (ii) is that the tax is not paid by dissaving but by saving in period t which causes the loss of the business sector. Eventually, the real taxation, i.e. the output transfer of period 1, is trailed in the nominal sphere. The household sector gains NOTHING by this delay. Just the opposite, the balanced budget case is the most advantageous for the household sector. Alternative (iii), i.e. budget deficit with money printing, is the most advantageous for the business sector. This is the version that is promoted by MMT and the other deficit spenders.#4

To argue in favor of deficit spending with the slogan “We owe the debt to ourselves” is either a testimonial of utter scientific incompetence or deliberate political deception of the general public.

Egmont Kakarot-Handtke

#1 10 steps to leave cargo cult economics behind for good
#2 Wikimedia AXEC31 Elementary production-consumption economy

#3 MMT was right all along: Gov-Deficits do NOT cause inflation
#4 Keynesianism as ultimate profit machine

Related 'Settling the Theory of Saving' and 'Meet the MMT smart arses' and 'No MMT illusions! YOU are going to pay for it' and 'How to pay for the war and to be bamboozled by economists' and 'Stephanie Kelton sells children into debt slavery'. For details of the big picture see cross-references Profit/Distribution.

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