Structural Deficits Are Deflationary

Reading and analysing economists’ articles from an MMT viewpoint can be interesting if only to see where they go wrong.

There is a classic in the article “Pay rises didn’t cause this inflation mess – the Bank did”. Andrew Lilico is an economist that leans towards the monetarist bent and states the following:

If, for example, extra money is printed and used to fund a higher budget deficit so government spending is higher for the same amount of taxes, that will tend to boost demand and drive the price level higher. It is inflationary.

That is 100% and 180 degrees wrong.

If government spending is higher for the same amount of taxes and thereby leaves a higher budget deficit, that will tend to decrease demand and drive the price level lower. It is deflationary.¹

Definitions

Before we go into why, it is worth defining some mainstream terms we tend to avoid in MMT.

“Deficit Spending” is “the amount by which spending exceeds revenue over a particular period”.

A “Structural Deficit” is “that part of the deficit which is not related to the state of the economy”. In other words, it is a permanent increase in the quantity of deficit spending.

We need to define these, as several alternatives exist.

The Belief

As we can see from the article quote, there is a belief in the mainstream that deficit spending is inflationary and that a structural deficit will change the price level upwards.

In contrast, the part of government spending matched by an increase in tax raised will not affect the price level.

MMT shows this is backwards. There is far more inflationary pressure from government spending that causes an increase in taxes than from deficit spending.

Think Like an MMTer

Much of this arises from the centrality of endogenous money and how MMT sees the overall spending process.

We see spending as an impulse that decays over time as people spend their earnings, earn what others have paid and spend it again, like a stone skipping across a pond.

The stone is government spending using freshly created money. Each skip is a tax point, which reduces the size of the next spending hop until the stone finally sinks, consumed by the ripples of taxation. The higher the tax, the rougher the stone, the bigger the ripple and the fewer the hops before it sinks.

This process is what government spending matched by taxation looks like - a whole load of additional transactions that may or may not be inflationary.

The overall price impact will depend upon multiple institutional and structural factors. Any programme design needs to take these into account.

However, the critical point from the stone-skipping analogy is that you always get ripples. Those ripples are the percentage-based transactional taxes functioning as an automatic stabiliser.

When the government buys things, you will get an increase in taxation because the government purchases things like a consumer rather than a business. There is no scope to offset or reclaim tax.

A Public Sector Worker Example

Consider a pay rise for civil servants of £1500.²

For many, this would attract 20% income tax, 12% National Insurance, 9% student loan repayment and a 5.45% pension contribution, reducing the net payment to the individual to £803.25. On top of that, the department would pay 13.8% Employer’s National Insurance. The Civil Service Pension Scheme would mark up their liabilities by 71% of the pay (offset by the 5.45% employee contribution).

Overall the amount requested from Parliament would be £2690.25, of which £803.25 (29.8%) would end up in the hands of the civil servant, £822 (30.5%) would end up as tax, and £1065 (39.7%) would be allocated to ‘Pension liability’ in the pension scheme.

Those are the numbers, so let’s flesh out the quote with them.

£2690.25 of extra money is ‘printed’³, creating an initial budget deficit of £2690.25 by accounting identity. £1065 is requested by the pension scheme, and £1625 by the employing department. £803.25 is paid to the individual and £822 to HMRC via the usual 1866 Act s15(3) mechanism.

We now have a budget deficit of £1868.25. To get back to the ‘same amount of taxes’, we must stop £822 of tax from being collected from the non-government sector. That would mean suppressing demand - more saving and less spending - which is deflationary.

A Public Sector Supplier Example

Let’s say the government purchases more seats at their outsourced payroll supplier, for which the bill totals £1500.

Suppliers charge 20% VAT on services, making the VAT-inclusive charge £1800.

Government requests £1800 from Parliament to settle the bill. Treasury creates the £1800 via the 1866 Act s15(3) process, automatically creating a £1800 budget deficit by accounting identity. The supplier receives all the money and accounts for VAT to HMRC in the usual way, reducing the budget deficit, and therefore the quantity of deficit spending, to £1500.

Further down the line, the supplier will pay tax on any extra employee hours needed to deliver the increased service. If they don’t need additional hours, taxes become due on the increased profit. Both of these would reduce the quantity of deficit spending further.

Again, getting back to the ‘same amount of taxes’ would mean suppressing demand, which is deflationary.

A Net Cash Example

Now you might argue that is cheating, even though that is how the government accounts for its activities. Instead, we should discount the internal government shuffling, including the VAT cover for their private sector suppliers, and consider the strict net cash position.

As we saw in the public sector worker example, we create £803.25 of new money via the 1866 s15(3) process and pay it to the individual’s bank account. That leaves a net budget deficit of £803.25 and no additional taxation.

But look what happens when we ‘boost demand’.

Let’s say the individual purchases an item that has been sitting on a shelf for a while. Immediately that incurs 20% VAT - increasing taxes and reducing the deficit by £160.65.

Or we could raise the price level by outbidding somebody in an eBay auction. An item that would have sold for £200 now sells for £250⁴. But as the taxation auto-stabilisers kick in, the same problem arises. The extra £50 is taxed at 20%, increasing taxes and reducing the deficit by £10. If the person outbid spends elsewhere, further tax would arise, reducing the deficit again.

No matter what we demand, we create taxation ripples that reduce the deficit. Boosting demand always boosts taxation revenue, and eliminates an amount of deficit spending.

For taxes to ‘stay the same’, all the individual can do is leave the money in the bank. The stone cannot be allowed to bounce. Net additional spending cannot happen.

Even here, when, in the traditional manner of economists, we have made the inconvenient truths ’exogenous’, deficit spending is inflation neutral.

Conclusion

Switching to the endogenous money view and abandoning the mythical market for loanable funds fundamentally alters how we view budget deficits.

Deficit spending means the government got what it wanted at the prescribed price, and those outbid just banked the cash or paid off a loan.

Some may dismiss this as a ‘Treasury View’, but that is backward. In the Treasury View, crowding out of money comes first. That can’t happen in an endogenous system.

In the Deficit Spending View, deficit spending ‘crowds out’ in the physical sphere first, and those crowded out decide not to buy anything else. If they had consumed further, more tax would materialise. That would reduce the amount of deficit spending and increase the amount of tax-matched spending.

When the government decides to increase its purchases, it’s not the ‘deficit spending’ or the ‘structural deficit’ we should worry about.

The inflation risk lies elsewhere - in the spending taxed to destruction over many transactional hops.

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