Paying for Katrina, another view
- From: William F Hummel <wfhummel@xxxxxxxxxxx>
- Date: Mon, 10 Oct 2005 08:08:43 -0700
How Will America Pay for Katrina?
(Why are we even asking this question?)
by Tom Nugent
NRO Financial, Contributing Editor
September 27, 2005
In rapid-fire succession, mainstream economists, pundits, and freshman
politicians have offered various solutions to paying the costs of
Katrina. President Bush has proposed spending $200 billion to rebuild
the ravaged Gulf Coast, while the president?s detractors hold that the
resulting larger budget deficit will penalize future generations and
drive interest rates higher. Budget conservatives, meanwhile, have
offered the Hooveresque prescription of spending cuts, postponed tax
cuts, and higher taxes to pay for hurricane damage.
We?ve been here before. Only a couple of years have passed since
similar arguments were put forth about the budget impact of tax cuts
while we?re spending on the Iraq war. Following these warnings of
too-much-government-deficit spending, the economy rebounded, there was
no ?crowding out,? and longer-term interest rates held steady (even as
the Federal Reserve removed accommodation by raising short rates). The
concerns of the budget-deficit hawks didn?t pan out.
Let?s take another look at the current concerns voiced by both
Democrats and Republicans regarding deficit spending and put them into
the proper perspective.
The budget deficit will be too large with both the Katrina spending
and the tax cuts; interest rates will rise dramatically. Budget
deficits are only too large if they usurp the private economy?s need
for physical capital and labor, thereby precipitating an inflationary
surge. In previous recessions, the deficit reached 5 percent of GDP
before the economy improved, as it did towards the end of 2003. Today
it is about 2.5 percent of GDP. Using history as a guide, until the
deficit gets to 5 percent of GDP, the economy will have too much
fiscal drag to maintain its potential growth path. We need a bigger
budget deficit, especially when economic and monetary forces are
acting to restrict economic growth.
Short-term interest rates, meanwhile, are controlled by the Fed and
the market?s anticipation of what the Fed will do down the road. While
the Fed has control over the federal funds interest rate, the factors
influencing long-term interest rates are not directly connected to the
Fed?s current policy. As the Fed has acted to drive up short-term
interest rates over the past two years, long-term interest rates have
remained relatively stable. The recent swing from a huge budget
surplus to a rising federal budget deficit has had no impact on
interest rates. Rates went lower, and then higher, to exactly where
the Fed voted them to be. Arguments that interest rates are going
higher because of deficits are misplaced; interest rates are going
higher because of Fed policy.
How does the federal government pay for the damages caused by Katrina?
Does anyone asking that question actually know how the government pays
for anything? Essentially, the federal government pays for things in
just one way ? it credits a member bank account. Let?s review the
process: The federal government writes a check to a construction
company to pay for a bridge. The construction company deposits the
check at a bank. When that check clears, the Fed credits the bank?s
reserve account at the Fed, and then the bank credits the company?s
bank account with ?good funds.? Bottom line: Operationally, virtually
all of the federal government?s spending per se consists of the Fed
crediting an account ? that?s all. The federal government doesn?t have
any ?box of money? that gets ?filled? from tax collections and the
proceeds from new Treasury securities and then gets ?used up? by
spending or lending. This is an operational reality. In today?s world
of non-convertible currencies, spending is necessarily nothing more
than ?score keeping.? (If one football team scores a touchdown, and 6
points are added to its score, does anyone ask where the scorekeeper
gets the points?)
Likewise, tax payments simply reduce account balances in the private
sector. Nothing ?goes? anywhere; the government doesn?t ?get
anything.? To reinforce this point, if you pay your taxes in actual
cash, or buy Treasury securities (government bonds) with actual cash,
the Fed shreds the cash. Likewise, if you donate cash to the federal
government for Katrina, it shreds it. In fact, if you take a $100 bill
and burn it, you?ve donated that $100 to Katrina! Operationally, the
entire spending process is not constrained by government ?revenue.?
Whether or not the government has collected taxes or borrowed is not a
factor in the payment process. Any constraints on the process can only
be ?self imposed.?
So, the actual ?paying for Katrina? is not the issue. The issue is the
real economic ramifications of the proposed spending or the proposed
tax increases ? the impact on inflation, output, growth, employment,
distribution, etc. Let?s take a look at some of these entities:
Is higher inflation coming? Perhaps. Excess government spending leads
to higher prices, particularly with rising energy costs, excess
capacity in the rest of the system notwithstanding. But has anyone
actually expressed this concern? No. There have been no estimates as
to how much the additional (one time) Katrina spending will add to
inflation. While Fed Chairman Alan Greenspan has provided Congress
with detailed analysis of the relationship between interest rates and
budget deficits, he has not documented the inflationary impact of such
government deficits. The Japanese example of record budget deficits
and deflation may give him cause to pause.
Will Katrina spending cause interest rates to rise? Hardly. The drama
surrounding last week?s fed funds rate hike concerned the possibility
that Katrina would cause the Fed to pause in their current policy of
raising short rates. It?s not a case of interest rates jumping up on
their own. Interest rates go up or down only when the Fed thinks it?s
a good idea.
Will private borrowers be crowded out? Impossible. The causation is
?loans create deposits,? as taught on day one of every traditional
money and banking class. The act of borrowing itself creates exactly
that same amount of new liabilities (deposits). The process is ?self
funding? and circular, as a matter of accounting. The concept of a
?pool of savings? that somehow gets ?used up? by borrowers is a
throwback to the time of fixed exchange rates and gold standards, and
has no application in today?s floating-exchange-rate world.
The true economic cost of Katrina is the real, physical resources
committed to repairing the damage that otherwise could have been used
elsewhere to expand productivity or improve overall standards of
living. But with today?s excess capacity in everything but energy,
there is not going to be much of an opportunity-cost to rebuilding,
apart from temporary dislocations of building materials and energy
production. In other words, shortages of goods and services due to
rebuilding should be temporary and modest.
In fact, with today?s modest expansion seemingly winding down
(pre-Katrina), the increase in federal government spending may very
well result in a net boost in domestic demand, enough to sustain the
current moderate recovery and help keep the real estate markets afloat
another year.
Politicians who advocate the elimination of tax cuts and/or cutting
other federal spending mistakenly believe that a smaller federal
deficit will somehow ?pay for Katrina.? We need our leaders to get ?in
paradigm? now.
.
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