September 27, 2005, 8:25 a.m.
How Will America Pay for Katrina?
(Why are we even asking this question?)

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.

— Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and principal of Victoria Capital Management, Inc.

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