Voters, take heed: Government can’t have a family-like budget

I once had a colleague who, together with his wife, had six different savings accounts. Each payday they would put a certain number of dollars in the car repair account and other sums in the Christmas, vacation, children’s college, new car purchase and retirement accounts.

I asked him why they did not just maintain one consolidated savings account for these varied purposes rather than six of them, which multiplied their bank fees. Why did they earn paltry interest on passbook savings when they had an 11 percent mortgage?

He replied that their system was the only way they could discipline their spending and not have fights over money.

This brings us to Al Gore’s economic plan and to what logic professors call a “fallacy of composition.” Last week, Gore proposed three things: establishing a “rainy day fund,” not spending Social Security trust funds and paying down the national debt. In reality, all three of these are the same thing. Al Gore has been around the federal government long enough to know that, but he obviously believes that the charade of three different funds will win points with the U.S. electorate. Maybe he is right.

A fallacy of composition is an error in reasoning against which every introductory economics textbook cautions in Chapter 1. It is the erroneous assumption that what is true for an individual is necessarily true for a larger group. The classic example is assuming that because any one individual can see better if she stands up at a basketball game, everyone will be able to see better if the whole crowd stands up.

Wrong! U.S. voters apparently believe that because they can discipline their spending by setting up separate bank accounts for different purposes, the federal government can do the same. This is not true. The government differs from a household in that it can create and destroy the very money that it purports to save. Moreover, absent some sort of “privatization” of treasury balances, the federal government effectively owns the banks in which it keeps any positive balances.

The federal government is like a household that has income, expenses, one checking account and a credit card that it never pays off completely. Every day or week it takes in money and pays bills. If revenues exceed expenses, it pays down the balance on its credit card. When expenses are greater than revenues, it draws cash from the credit card.

It never keeps any more in its checking account than it will need to cover the checks it writes. This would be costly since it doesn’t earn any interest on that account and it pays interest on the credit card balance.

Some of you may be saying that is about the way you run your own family finances, but that in a few years, after the kids’ braces are paid for or they get out of college, you are going to open a savings account, yes sir! Why can’t the government do the same?

It can’t because the Federal Reserve system handles the federal checking accounts, or “acts as fiscal agent for the government” to use the official term. The Fed doesn’t have savings accounts or pay interest. Pass a law making it do so, you say. Well, there really is no advantage to having government funds in an account on which the Fed is required to pay interest while at the same time the Fed owns Treasury bonds on which it is earning interest.

It is much more straightforward to just pay off that amount of bonds. In other words, pay down the national debt. Some may ask why not just keep some money in the Treasury? There is a practical question of how this could be done, pallets of $20 bills in the basement perhaps? There is the more important problem that funds somehow held in the Treasury would simply disappear from the money supply with deflationary effects, only to surface as a money supply increase with inflationary effects when spent.

But, you protest, if it is in a rainy day account at the Fed, isn’t that easier to spend when it is needed than going out and borrowing more money? Not really, especially for the federal government. My colleague was right to maintain some funds in low-interest savings accounts while paying 11 percent on a home mortgage simply because it gave him liquidity.

He could tap the savings in an instant, but it would take him weeks to refinance the house. This is not true for the federal government, which pays off mature bonds and issues new ones virtually every business day. It can pay off more and issue fewer new bonds when we have budget surpluses and switch to the opposite whenever a rainy day comes.

All this question of whether the government should go through an elaborate accounting charade of creating a rainy day fund to accompany the existing charade of Social Security, highway and airport “trust funds” only obscures the key issue. Continued financial stability of the U.S. government depends on continuing fiscal prudence by Congress over the long term. It is a fundamental principle of representative government that one Congress cannot bind succeeding ones to a particular course of action.

During the past two decades, Congress experimented with all sorts of different smoke-and-mirrors accounting gimmicks, such as declaring Social Security on or off budget, deferring expenses to subsequent budget years or categorizing various spending items as “emergency” and not subject to some self-imposed cap.

All this is “sound and fury, signifying nothing” in Shakespeare’s memorable words. All that matters in the long run is how much the government takes in through taxes and how much it spends. Al Gore and George W. Bush should both know that, and the American public should understand it also.

© 2000 Edward Lotterman
Chanarambie Consulting, Inc.