Obama Faces His Own “Teachable Moment”

Thursday, 11/4/2010 - 10:49 am by Marshall Auerback | 18 Comments

marshall-auerback-100The new Congress is likely to put extreme economic positions to the test.

The President loves teachable moments. Well, he’s about to get one when the new Congress is sworn in next January. During the midterm elections, we were constantly told that businesses and households were so terrified of higher future taxes associated with budget deficits that they were not investing or spending. Our “spendthrift” government, then, was responsible for killing economic growth (even though most of the spending continued Bush’s policies and kept the rich bailed out). The spending led to the constant chorus, heard endlessly as the election results poured in Tuesday night, that the “socialistic” fiscal stimulus actually undermined growth, and that fiscal restraint (”living within our means as a household does”) was the key to growth.

But now it’s put up or shut up time for the fiscal austerian brigade. What are they going to cut? How are those cuts going to lead us back to economic prosperity? When I hear people such as Congressman Eric Cantor discussing the need for the government to go on a diet, I wonder if he actually considers that his party’s end objective, if successful, will simply transfer debt back to private households and businesses.

To have a “teachable moment,” you need a teacher who’s on top of his material. The President’s Wall Street tutors have shown themselves to be economic quacks. They are as responsible as anybody for driving this economy into the ditch that Obama invoked so much during the midterm election campaign.

So let’s try to give the President a fresh tutorial. God knows he’ll need it when he is discussing this stuff with the likes of Rand Paul. When the government runs a surplus, the non-government sector has to be in deficit, and vice-versa. There are distributional possibilities between the foreign and domestic components of the non-government sector, but overall that sector’s outcome is the reverse image of the government balance. This is a fundamental bookkeeping reality.

So the President can start by pointing out that when the new GOP Congress and its Tea Party allies argue that the government sector should be in surplus, this is tantamount to saying that the non-government sector should be in deficit. The fact is that US net exports today are not strong enough to simultaneously support a reduction in private debt and a public surplus while pushing growth to its full employment level. If the foreign sector is in deficit, national accounting relations mean that a government surplus will always be reflected in a private domestic deficit, which is precisely what happened during the 1990s.

It’s simple. If there is a current account deficit (which we have today in the US), and both the government and private domestic sectors implement plans to reduce spending and pay down debt, there will be shortfall in aggregate demand, which will generate cuts in output and income. These income shifts drive the budget towards or into deficit and stifle the private sector plans to save. So eventually the actual balances add to zero. But neither the government, nor the domestic private sector, will be achieving their plans. Cutting government spending now means growth will slow. The automatic stabilizers will kick into gear. Tax revenues will fall further. DEFICITS WILL GO HIGHER. Consequently,  the attempt to force people to “live within their means”, as our new GOP-led Congress desires, will actually create precisely the opposite effect.

Throughout the first two years of his Presidency, Obama’s “negotiating strategy”, if one could call it that, indicated he wasn’t going to take Republicans on, but try to find common cause with the other side. Negotiation ultimately implies a willing partner. Fat chance. If the President’s tactics had been used by King Solomon, the child would have been cut in half in the spirit of “bipartisan compromise”.

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Enough already. The showdown moment will come soon enough. We’ve got the expiration of the Bush tax cuts coming up at the end of the year. The President might well extend the tax cuts permanently. Or he and his party might insist that the provision only applies for those earning less than $250,000. What if the GOP doesn’t compromise? Gridlock means taxes go up in the New Year, which further drains aggregate demand.

And what about the debt ceiling? The new Congress is due to vote on raising it early next year. Although many of us have long argued that a sovereign government faces no OPERATIONAL constraint in terms of spending money, it is also clear that we have imposed many LEGAL constraints, which do create potential solvency issues for the US. America’s institutional arrangements still reflect gold standard conditions, all the way through.

Consider a simple example: suppose the Treasury account hits zero and it writes yet another check. Will the check bounce? Back in the days of the gold standard, this meant there was no gold left in the vault. If the Treasury promised someone more gold, it could not deliver. The check would indeed bounce, and the central bank would be forced to raise rates in order to attract gold flows back into the country to fund future spending.

But we are no longer on a gold standard, and for the Treasury to clear its check, it must adhere to agreed debt ceilings, along with laws that mandate that the Treasury issue bonds to “fund” all government expenditures. We could easily circumvent this requirement by letting the Treasury account go into the negative (overdraft) at its “bank”, the Federal Reserve. The Fed would need to let the Treasury account have a “-” in the spreadsheet cell that tracks its number, as Winterspeak has pointed out.

Currently, this is illegal. However, when the Treasury did not have sufficient funds in its deposit at the Fed in the past, it temporarily circumvented this problem by selling bonds to special depositories that are allowed to buy the bonds by crediting the Treasury’s deposit. The Treasury would then transfer its deposit to the Fed before spending. This would normally result in a reserve debit from the accounts of those banks, but the Fed would allow a “float” (i.e., postpone the debit) because subsequent spending by the Treasury would restore the reserves. This expedient, however, can only work for a matter of days, because if the new Congress does not raise the debt ceiling or change the law mandating that we “fund” our expenditures via bond sales, the US Government will have decided to bounce its own checks. Its next decision, one presumes, would be to default.

That’s the legal constraint. It’s dumb, but it’s real. It also means, for example, that around $80 billion of spending power will be withdrawn from the economy as the temporary extension of unemployment insurance expires. That might fire up the GOP’s base, but it could well prove a fleeting pleasure. Consider the possibility (as Lawrence O’Donnell did Tuesday night) that the new Senator from Kentucky, Rand Paul, for example, leads a filibuster preventing the debate on allowing the government to raise the debt ceiling. How will the billionaires who have funded Tea Party candidates react when one of their own actually acts out of principle and potentially creates a new financial crisis? In the event that Congress is unable to raise the debt ceiling, it effectively forces the American government to default on its debt. Sure, the markets might take it in their stride for a few days, but after a few weeks, will they remain sanguine?

Sounds improbable? Well, re-read your history of the 1994 “Contract with America” Congress, led by then Speaker of the House Newt Gingrich. Under Gingrich’s direction, the US Congress decided to default on US Government debt by refusing to raise the debt ceiling. The only reason the Government did not default was because Treasury Secretary Robert Rubin was able to make a payment from an account balance hitherto undisclosed to Congress. Just about every time the self-imposed US debt ceiling is about to be breached, this issue arises, and yet nobody ever considers the possibility that US bonds would stop being “money good”. Normally there’s a good reason for that: After members of Congress dutifully wring their hands and declaim the burden the Administration is placing on future generations, the debt limit is invariably increased. That could well change, given the fanaticism of some of our new Congressmen and Senators. Will Obama be in a position to do something about it? Will he explain that bond sales are a completely voluntary and self-imposed operation for any sovereign government? Probably not, especially if one is to judge from the press conference he held early yesterday morning. Deficit reduction was one of the main things he talked about. But the President better figure out something soon. His latest “teachable moment” is just around the corner.

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

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  • Hi Marshall,

    I really wonder about this. Congress mandates that the Government can’t deficit spend unless it issues debt in one-to-one dollar correspondence. But if it refuses to raise the debt ceiling, it cannot comply with the mandate about issuing debt. Also, it’s the law that the US Government pay its debt obligations as these fall due, and fulfill the terms of various spending programs which require expenditures.

    So, in this situation the Executive has numerous legal mandates in conflict and the President has the duty to faithfully execute the laws. Why, in this situation, can’t the Attorney General argue that Congress’s refusal to lift the debt ceiling has created a constitutional crisis and that it is the interpretation of the Executive Branch that the refusal to raise the debt ceiling negates the legal requirement that the Government must issue debt dollar-for-dollar in order to spend. And further, that the Government has unlimited constitutional authority and in some cases obligations to spend and create fiat money as long as such spending has been previously authorized by Congress, whether or not the debt ceiling is extended.

    In line with this interpretation the Executive Branch orders the continuation of all Federal spending until the constitutional crisis is resolved, and orders the Fed to mark up its accounts at the Fed in line with its directives so that spending can continue and Treasury Accounts will have positive balances. Meanwhile, the Executive challenges Congress to remove the conflict created by its conflicting mandates through either:

    1) Raising the debt ceiling

    2) Ending the constraint that debt must be issued by the Treasury to cover Federal expenditures previously appropriated

    3) Revoking the Federal obligations to spend forcing the Executive to exceed the debt limits; or

    4) Seeking a Supreme Court judgment resolving the conflicts among conflicting Congressional mandates on the Executive.

    What would be wrong with something like this? Why should the interpretation be that the US must default on its obligations? After all it’s not even the explicit will of Congress that any such default occur, but only the will of one or a small number of Senators who will not let the Congress express its will.

    Posted by Joe Firestone | November 4th, 2010 at 11:48 am

  • Joe,
    I’m just reading the law as it stands and it appears that ultimately, the debt ceiling is pretty sacrosanct as far as the law goes. I’ve certainly never seen any precedent to the contrary which would support your interpretation.

    Posted by Marshall Auerback | November 4th, 2010 at 12:25 pm

  • Marshall,

    How would any Court precedents have arisen if all Presidents since we’ve gone off the gold standard have simply decided to adopt the interpretation that the debt ceiling trumps the other conflicting elements?

    And what does precedent tell us about what would happen if an Administration decided to adopt another legal interpretation closer to mine? There are no Supreme Court decisions governing something like this are there?

    Just asking the question and pointing out that the Administration may have other options apart from just shutting down because Congress won’t raise the debt ceiling due to a filibuster.

    Posted by Joe Firestone | November 4th, 2010 at 1:42 pm

  • But aren’t bond obligations equally sacrosanct? Couldn’t the government stop paying federal salaries, for example, as opposed to defaulting on bonds?

    Posted by Detroit Dan | November 4th, 2010 at 1:42 pm

  • Or perhaps the Fed could just keep buying up the bonds, in which case the Treasury could default on payments to the Fed, with no real effect…

    Posted by Detroit Dan | November 4th, 2010 at 1:44 pm

  • At some point, people like Rand Paul will realize how the system works. No that we’ve got QE, more and more people are begin to understand that monetization of the debt is not a big deal.

    Posted by Detroit Dan | November 4th, 2010 at 1:45 pm

  • Great post, Marshall.

    FYI, in addition to Winterspeak’s excellent post, I went into detail on the operational constraint vs. legal constraint issue here: http://www.nakedcapitalism.com/2010/08/guest-post-modern-monetary-theory-%E2%80%94-a-primer-on-the-operational-realities-of-the-monetary-system.html

    Posted by Scott Fullwiler | November 4th, 2010 at 1:49 pm

  • @Detroit Dan. I think the Executive could do that. My point is that there are different ways for the Executive to respond including declaring a constitutional crisis.

    If the Congress fails to raise the debt limit because Ron Paul filibusters, and if the Senate refuses to get rid of the filibuster, the Executive could even sue the Congress seeking abrogation of the filibuster on grounds that the Constitution calls for majority rule in the Senate, and that inaction caused by the filibuster threatens to shut down the Government.

    Of course the Court would be reluctant to hear such a case. But my point, again, is not that such a scenario would happen, but rather that there are many scenarios we might see depending on how the Obama Administration interprets its position and formulates its response strategy. Who knows what wonky response is in store for us.

    Posted by Joe Firestone | November 4th, 2010 at 1:52 pm

  • Marshall,
    I suspect the GOP and the deficit hawks amongst the Democrats will actually push to eliminate the automatic stabilizers as well. That sounds extremely foolish to us, of course but these people are nothing if not extremely foolish.

    Posted by Patriot | November 4th, 2010 at 1:53 pm

  • The did stop paying the military for a short while back in 1995 (November, if I remember correctly).

    Posted by Jason Ray | November 4th, 2010 at 3:35 pm

  • Joe,

    There are ways to subvert the debt ceiling limit. Rubin did it in 1995-96 but probably can’t go on for too long. I suspect that the court would view this as a political problem and stay out it. It’s time to Obama to “man up” (sorry I couldn’t resist) because GOP will definitely want something in exchange for voting to raise it.

    Posted by Dennis Kelleher | November 4th, 2010 at 5:18 pm

  • Hi Dennis, I know there are some. Why can’t the Ds raise the debt limit now, before the new Congress convenes? They all ought to “man up.” Michael Moore suggested that the lame duck Senate ought to re-convene and pass Nancy Pelosi’s 100s of outstanding bills before the lame duck is over. To do that they’d have to use the nuclear option to get rid of the filibuster and then ride roughshod over the Republicans. But why not?

    What could the GOP do? They won’t have the Senate in the new Congress. All they can do about it is bleat. If the bills work out well for Americans, the Ds benefit in 2012. If not, they’ll be gone anyway, because there certainly won’t be much good legislation coming out of the new Congress.

    Posted by Joe Firestone | November 4th, 2010 at 5:29 pm

  • Joe -

    I agree with you but there are too many conservdems in senate to pull that off.

    IMO, Dems are too weak to stop this right wing onslaught that GOP is about to unleash.

    Posted by Dennis Kelleher | November 4th, 2010 at 5:59 pm

  • Yes, The Dems have been cultivating weakness and neoliberalism for 35 years now.

    Posted by Joe Firestone | November 4th, 2010 at 6:35 pm

  • Marshall, there are many legal precedents & opinions, from John Marshall to the 1990s, which contradict some of what you say about the law. Joe Firestone and Detroit Dan get it more right imho.But aren’t bond obligations equally sacrosanct? No, they’re MORE sacrosanct. [than debt limits]

    I’ve written about this on this over at Warren’s and other places several times. Some government spending, including, but not restricted to, bonds, is for “Government Obligations.” These are explicitly and implicitlyCONSTITUTIONALLY PROTECTED. Debt limits, 1-1 matching, no overdraft etc are ordinary federal law, which is trumped by Government Obligations, just as if each debt obligation were included in the Constitution. There is a long line of Supreme Court cases, and a recent relevant Obama DOJ opinion - thank god somebody there knows the law - that says that earlier spending authorizations creating government obligations supersede, trump, override, grind into the dust any later congressional or executive action, and held that the natural interpretation of a recent act of Congress should be ignored because it conflicted with well settled constitutional law.

    What should happen is that bond and obligation holders would be paid. If this required breaking lower level law - so what? It would be by that token unconstitutional law, not binding on the executive. But since Congress has seignorage power, and delegated it to the Treasury secretary, he might even be legally forced to “print” / coin a zillion dollar coin and deposit at the Fed, if that is the only way the administration could figure to satisfy both the higher and lower level law.

    Posted by Calgacus | November 4th, 2010 at 8:22 pm

  • There is another way to stimulate the economy, to reduce the unemployment rate and keep people in their homes, which would solve the foreclosure crises. The Plan I am talking about does not require taxes to be increased or decreased, or more deficit spending. It is unnecessary for the Fed to inflate the economy with quantitative easing. Inflation will make us all poorer, and then more people will become government dependent, increasing local, state and federal government’s liabilities.

    The first thing Congress should do, before January 2011, is correct the economic mess that they helped create. I don’t think either party knows how to do it correctly.

    Have you ever seen people that have a problem they don’t know how to solve? They will get frustrated and start the blame game and start bickering. This is how Congress is acting. They don’t have a viable plan to solve the unemployment and foreclosure crisis!

    Now that the Republicans have control of the House they will do what they have always done. Lower taxes for the people that have money and then hope they spend the money they don’t pay in taxes in a productive way. Neither one of the parties have enough votes to override a veto. Each political party will try to convince the moderates of each party to vote with them. Unless someone comes up with a plan that everyone believes will work, we will have much of the same gridlock in Congress that we have had in the past.

    When the people that have money have inflation expectations, they invest their money to either protect their money from inflation. or they invest it to make inflation created “paper profits.” These types of investments do not increase jobs or help the middle class. In fact they increase the inflation rate, because the people that have money can obtain loans from the bank, thereby creating more money and more false demand in the economy. These “investments” don’t increase the standard of living of the people in an economy.

    What increases the “real wealth of a nation”, and the standard of living of the people in an economy, is increased production of goods and services, and people’s ability to participate in the economy with a job and sufficient disposable income, and then the willingness to make more than subsistence purchases.

    Congress thinks the Federal Reserve (Fed) is responsible for curing recessions and inflation, but the Fed’s tools can’t correctly fix the problem. It will have to be done by Congress. What the Fed has done so far has loaded the pipeline with a lot of cash. The Fed has announced they are going to load another $900 billion dollars into the pipeline in the next six to eight months. It will not do any good for Main Street, because unless the money is lent to Main Street, it will not help the middle class or small businesses reduce unemployment.

    Main St. is where the problem with our economy is, not Wall St. or Big business. Currently Wall St. and big business are doing fine. The middle class and small business have been left out of the economy’s recovery. Without the middle class and small businesses included in the recovery, the stock market and the banking system will start imploding on themselves.

    Banks and Wall St. don’t, by themselves, increase aggregate demand. When businesses see more people able and willing to make purchases, they will hire the unemployed. When the unemployed are hired they will increase aggregate demand, because their disposable income will have increased. When we see the unemployed being employed that is when we will have a viable economic recovery in our country.

    For the solution to the economic crisis go to: http://www.recoverygovforthepeople.wordpress.com/ Become my friend on facebook and join the R.E.B.E.L.S. to participate in America’s economic recovery. http://www.facebook.com/profile.php?id=1651940167/

    Leonard C. Tekaat

    Posted by Leonard C. Tekaat | November 4th, 2010 at 11:37 pm

  • Neither investing nor spending:

    I’m left wondering, exactly what WAS this well-lubricated, financial aristocracy doing; hiding money under a loose floorboard?

    I also find it ironic that fiscal barons that freely gamble vast sums of money would be terrified of paying taxes. It makes sense. No?

    Posted by Village Idiot | November 5th, 2010 at 10:01 pm

  • Joe, I am not a lawyer but I think that the Executive could argue that the 14th amendment section 4 obviates default and order the Treasury and Fed to comply. Congress could seek redress in the courts, but precedent indicates that the Executive is correct in its interpretation and courts would likely uphold it unless they wanted to reverse precedent. However, it seems unlikely that the Roberts court would force the US government into default.

    But this would be one big kerfuffle, and it would probably result in a constitutional crisis. The GOP leadership may find itself riding on the back of a tiger. Even if it can talk sense into the TP membership, the TP itself will go ballistic. Double bind coming.

    Posted by Tom Hickey | November 6th, 2010 at 8:05 pm

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