Monday, February 02, 2009

Some academic assumptions...

...regarding basic macroeconomic theory are wrong.

We do not live in a closed economy with one export.

We do not live in a world with commodity-backed currency.

The U.S. does not need to "finance" its debt. It does not need to "get" dollars in order to spend them. It does not need to exchange gold for currency. It does not need to go hat in hand to "creditor nations" in order to spend its currency. "Financing" is not the problem. Inflation is the problem.

So when I read that a very famous financial economist (closely associated with a certain midwest school that is my alma mater) has entered the debate with the following:

"1. Bailouts and stimulus plans must be financed.

2. If the financing takes the form of additional government debt, the added debt displaces other uses of the funds.

3. Thus, stimulus plans only enhance incomes when they move resources from less productive to more productive uses.

Are any of these statements incorrect?"

I must answer the question "yes". "Financing" is a misnomer for the U.S., armed with the world's only reserve currency. The Treasury market itself is best thought of as an interest-rate management system than a "financing" system for spending.

As for point 2., we are still stuck in the "sources and uses" type of thinking about "debt" here. This is not a U.S. company or municipality borrowing to spend. This is a sovereign with full control and ownership of its currency engaging in deficit spending...

Too often, brilliant people fail to question their assumptions. The chain of logic that results is often beautiful, but unfortunately of no use in understanding or prediction.

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