Ten Great Economic Myths

Our country is beset by a large number of economic myths that distort public thinking on important problems and lead us to accept unsound and dangerous government policies. Here are ten of the most dangerous of these myths and an analysis of what is wrong with them.

Myth #1

Deficits are the cause of inflation; deficits have nothing to do with inflation.

In recent decades we always have had federal deficits. The invariable response of the party out of power, whichever it may be, is to denounce those deficits as being the cause of our chronic inflation. And the invariable response of whatever party is in power has been to claim that deficits have nothing to do with inflation. Both opposing statements are myths.

Deficits mean that the federal government is spending more than it is taking in taxes. Those deficits can be financed in two ways. If they are financed by selling Treasury bonds to the public, then the deficits are not inflationary. No new money is created; people and institutions simply draw down their bank deposits to pay for the bonds, and the Treasury spends that money. Money has simply been transferred from the public to the Treasury, and then the money is spent on other members of the public.

On the other hand, the deficit may be financed by selling bonds to the banking system. If that occurs, the banks create new money by creating new bank deposits and using them to buy the bonds. The new money, in the form of bank deposits, is then spent by the Treasury, and thereby enters permanently into the spending stream of the economy, raising prices and causing inflation. By a complex process, the Federal Reserve enables the banks to create the new money by generating bank reserves of one-tenth that amount. Thus, if banks are to buy $100 billion of new bonds to finance the deficit, the Fed buys approximately $10 billion of old treasury bonds. This purchase increases bank reserves by $10 billion, allowing the banks to pyramid the creation of new bank deposits or money by ten times that amount. In short, the government and the banking system it controls in effect "print" new money to pay for the federal deficit.

Thus, deficits are inflationary to the extent that they are financed by the banking system; they are not inflationary to the extent they are underwritten by the public.

Some policymakers point to the 1982–83 period, when deficits were accelerating and inflation was abating, as a statistical "proof" that deficits and inflation have no relation to each other. This is no proof at all. General price changes are determined by two factors: the supply of, and the demand for, money. During 1982–83 the Fed created new money at a very high rate, approximately at 15 percent per annum. Much of this went to finance the expanding deficit. But on the other hand, the severe depression of those two years increased the demand for money (i.e. lowered the desire to spend money on goods), in response to the severe business losses. This temporarily compensating increase in the demand for money does not make deficits any the less inflationary. In fact, as recovery proceeds, spending will pick up and the demand for money will fall, and the spending of the new money will accelerate inflation.

Myth #2

Deficits do not have a crowding-out effect on private investment.

In recent years there has been an understandable worry over the low rate of saving and investment in the United States. One worry is that the enormous federal deficits will divert savings to unproductive government spending and thereby crowd out productive investment, generating ever, greater long-run problems in advancing or even maintaining the living standards of the public.

Some policymakers have once again attempted to rebut this charge by statistics. In 1982–83, they declare, deficits were high and increasing, while interest rates fell, thereby indicating that deficits have no crowding, out effect.

This argument once again shows the fallacy of trying to refute logic with statistics. Interest rates fell because of the drop in business borrowing in a recession. "Real" interest rates (interest rates minus the inflation rate) stayed unprecedentedly high, however — partly because most of us expect renewed heavy inflation, partly because of the crowding, out effect. In any case, statistics cannot refute logic; and logic tells us that if savings go into government bonds, there will necessarily be fewer savings available for productive investment than there would have been, and interest rates will be higher than they would have been without the deficits. If deficits are financed by the public, then this diversion of savings into government projects is direct and palpable. If the deficits are financed by bank inflation, then the diversion is indirect, the crowding-out now taking place by the new money "printed" by the government competing for resources with old money saved by the public.

Milton Friedman tries to rebut the crowding-out effect of deficits by claiming that all government spending, not just deficits, equally crowds out private savings and investment. It is true that money siphoned off by taxes could also have gone into private savings and investment. But deficits have a far greater crowding, out effect than overall spending, since deficits financed by the public obviously tap savings and savings alone, whereas taxes reduce the public's consumption as well as savings.

Thus, deficits, whichever way you look at them, cause. grave economic problems. If they are financed by the banking system, they are inflationary. But even if they are financed by the public, they will still cause severe crowding-out effects, diverting much-needed savings from productive private investment to wasteful government projects. And, furthermore, the greater the deficits the greater the permanent income tax burden on the American people to pay for the mounting interest payments, a problem aggravated by the high-interest rates brought about by inflationary deficits.

Myth #3

Tax increases are a cure for deficits.

Those people who are properly worried about the deficit, unfortunately, offer an unacceptable solution: increasing taxes. Curing deficits by raising taxes is equivalent to curing someone's bronchitis by shooting him. The "cure" is far worse than the disease.

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Originally published in The Free Market Special Issue (1984)

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