Deliberately reducing the national debt via taxation does contribute to depressions.

Deliberately reducing the national debt via taxation does indeed contribute to (and is not just coincident to) depressions. All seven times when this has happened in the United States, it has indeed been followed by a depression. In each case, the debt reduction is indeed a cause of, and not just coincident to, the depression. This post contains detailed confirmation from Stephanie Kelton and L. Randall Wray.

Highlights:

  • Kelton: “Each and every time the government substantially reduced the national debt, the economy fell into depression.”
  • Wray: “Every significant reduction of the outstanding debt has been followed by a depression, and every depression has been preceded by significant debt reduction.”

Basically, the issuer taxing lots of money out of the non-government sector for a nonsensical financial reason (such as reducing its debt that isn’t) is very bad because the currency issuer can create more currency on a whim. Currency users can’t.

Related posts:

GO BACK TO ALL MMT RESOURCES

This post was last updated January 7, 2021.

Disclaimer: I am a layperson who has studied MMT since February of 2018. I’m not an economist or academic and I don’t speak for the MMT project. The information in this post is my best understanding but I don’t assert it to be perfectly accurate. In order to ensure accuracy, you should rely on the expert sources linked throughout. If you have feedback to improve this post, please get in touch.

Stephanie Kelton, in her 2020 book, The Deficit Myth


The above table comes from page ninety five (in the Kindle edition). Here’s the relevant text from that section:

We actually did it once [eliminate the national debt]. 39 It was 1835—Andrew Jackson was president—and it was the only time in US history when the public debt was paid all the way down. That was long before the Federal Reserve was created, so the debt wasn’t gobbled out of existence by the central bank. 40 Instead, it was eliminated the old-fashioned way—that is, by reversing fiscal deficits and paying off bondholders. It didn’t end so well.

It took more than a decade to retire the entire debt. It happened because the government ran fiscal surpluses from 1823 to 1836. Since it was taxing away more money than it was spending in each of those years, it didn’t issue new debt. Instead, as bonds matured, the government simply paid them off. 41 By 1835, the US was debt free. It was also headed for one of the worst economic downturns the country has ever experienced. In hindsight, it seems obvious why things unfolded the way they did.

Fiscal surpluses suck money out of the economy. Fiscal deficits do the opposite. As long as they’re not excessive, deficits can help to maintain a good economy by supporting incomes, sales, and profits. 42 They’re not imperative, but if they disappear for too long, eventually the economy hits a wall. 43 As Frederick Thayer, the prolific writer and professor of public and international affairs at the University of Pittsburgh, wrote in 1996, “the US has experienced six significant economic depressions,” and “each was preceded by a sustained period of budget balancing.” 44 Table 1 details his findings.

The historical record is clear. Each and every time the government substantially reduced the national debt, the economy fell into depression. Could it have been a remarkable coincidence? Thayer didn’t think so. He blamed the “economic myths” that drove politicians to wrestle their budgets into surplus on the flawed belief that paying down debt was both morally and fiscally responsible. 45 As we see from the insights of MMT, government surpluses shift deficits onto the nongovernment sector. 46 The problem is that currency users can’t sustain those deficits indefinitely. Eventually, the private sector reaches the point where it can’t handle the debt it has accumulated. When that happens, spending grinds sharply lower and the economy falls into depression.

Since Thayer’s work was published, the US experienced one other brief period (1998–2001) of sustained fiscal surpluses. It happened during Bill Clinton’s presidency, and many Democrats still look back on it as a crowning achievement. The red ink was eliminated, and Uncle Sam was back in the black for the first time in decades. The surpluses began in 1998, and by 1999 the White House was ready to party like it was, well, 1999. 47 The following year, White House economists began working on a report titled “Life After Debt.” It was supposed to deliver the celebratory news that the United States was on track to retire the entire national debt by 2012.

At first, paying off the debt seemed like the kind of accomplishment that might be worthy of a national parade. The White House was preparing to feature the news in its annual Economic Report of the President . But then everyone got cold feet, and that chapter of the report was hidden from public view. We only know about it because National Public Radio’s Planet Money “obtained a secret government report outlining what once looked like a potential crisis: The possibility that the US government might pay off its entire debt.” 48 Instead of shouting it from the rooftops, White House officials quietly tucked it away. The reason? They were worried about the broader implications of wiping out the entire US Treasury market. It was a return to the love-hate relationship many public officials have with the national debt. On the one hand, the White House would have loved to eliminate the national debt. On the other hand, it couldn’t risk getting rid of all Treasuries.

What worried policy makers the most was the prospect of depriving the Federal Reserve of the key instrument it relied on to conduct monetary policy—government debt. At the time, the Fed was relying on government bonds to manage the short-term interest rate. When the Fed wanted to raise interest rates, it sold some of its Treasuries. Buyers paid for those bonds using a portion of their bank reserves. By removing enough reserves, the Fed could move the interest rate up. 49 To cut rates, the Fed would do the opposite, buying Treasuries and paying for them with newly created reserves. Without Treasuries, the Fed would need to find some other way to set interest rates. 50

In the end, the problem solved itself. By 2002, the surpluses were gone, and the US was no longer on track to pay down the national debt, much less retire the full amount. The federal budget moved back into deficit after 2001, when the stock market bubble—which had been supporting consumer spending—burst. A recession began in 2001. It was a fairly mild recession, but the damage had been done. 51

The footnotes referenced in the above passage

  1. Interested readers might enjoy Carl Lane, A Nation Wholly Free: The Elimination of the National Debt in the Age of Jackson (Yardley, PA: Westholme, 2014).
  2. The Federal Reserve System was created by the Federal Reserve Act in 1913.
  3. Treasuries pay principal and interest. You might have purchased a ten-year Treasury with a 5 percent coupon (interest rate). The government takes your $1,000 and pays you $50 each year for ten years. At the end of the tenth year, the government returns the principal amount of $1,000 to you.
  4. David A. Levy, Martin P. Farnham, and Samira Rajan, Where Profits Come From (Kisco, NY: Jerome Levy Forecasting Center, 2008), http://www.levyforecast.com/assets/Profits.pdf.
  5. As we’ll see in Chapter 5, countries that run trade surpluses are far less dependent on fiscal deficits. But countries like the United States—that is, those that run chronic trade deficits—are usually better off running fiscal deficits. Without them, growth becomes unsustainable. See Wynne Godley, “What If They Start Saving Again? Wynne Godley on the US Economy,” London Review of Books 22, no. 13 (July 6, 2000), http://www.lrb.co.uk/v22/n13/wynne-godley/what-if-they-start-saving-again.
  6. Frederick C. Thayer, “Balanced Budgets and Depressions,” American Journal of Economics and Sociology 55, no. 2 (1996): 211–212, JSTOR , http://www.jstor.org/stable/3487081.
  7. Ibid.
  8. I explore this in detail in Chapter 4. Also, see Scott Fullwiler, “The Sector Financial Balances Model of Aggregate Demand (Revised),” New Economic Perspectives, July 26, 2009, neweconomicperspectives.org/2009/07/sector-financial-balances-model-of_26.html.
  9. Apologies to Prince.
  10. NPR gained access to a copy, which is now public, through a Freedom of Information Act (FOIA) request in 2011. You can read the backstory at David Kestenbaum, “What If We Paid Off the Debt? The Secret Government Report,” Planet Money , NPR, October 20, 211, http://www.npr.org/sections/money/2011/10/21/141510617/what-if-we-paid-off-the-debt-the-secret-government-report.
  11. The interest rate is known as the federal funds rate. It’s the interest rate that banks charge one another when they lend reserves in the overnight market. When there is an abundance of reserves in the system, a bank that needs to borrow reserves doesn’t have to pay very much to get them from banks that have more than they want to hold. They’re cheap because they’re easy to come by. To achieve a lower interest rate, all the Fed has to do is flood the banking system with enough reserves to bring the price down to its target rate. It does this by purchasing.
  12. Kestenbaum, “What If We Paid Off the Debt?” Concern was that if the Fed had to buy other kinds of financial assets, it might look like it was picking winners and losers.
  13. Before the recession hit, the US economy grew rapidly, pushing revenues up sharply. The boom was largely the result of a stock-market bubble, which fueled the growth that moved the budget into surplus. As the bubble began to collapse in January 2001, the economy moved into recession. The fiscal surpluses didn’t cause the recession, but they set the stage for the more severe recession that began in 2007. For more on this, see Wynne Godley, Seven Unsustainable Processes (Annandale-on-Hudson, NY: Jerome Levy Economics Institute, 1999), http://www.levyinstitute.org/pubs/sevenproc.pdf.

The following excerpts come from L. Randall Wray in his 1999 paper, Surplus Mania: A Reality Check

From the section, “Reality Check”

The federal government has been in debt every year but one since 1776. Far from viewing government debt as a horror to be avoided, at least some of the founding fathers recognized the benefits. Thomas Paine proclaimed that “No nation ought to be without a debt” for “a national debt is a national bond.” Alexander Hamilton asserted that “A national debt, if it is not excessive, will be to us a national blessing.” Andrew Jackson, however, labeled the public debt a “national curse” and, like President Clinton, set out to retire it. By January 1835, for the first and only time in U.S. history, the public debt was retired, and a budget surplus was maintained for the next two years in order to accumulate what Treasury Secretary Levi Woodbury called “a fund to meet future deficits.” In 1837 the economy collapsed into a deep depression that drove the budget into deficit, and the federal government has been in debt ever since.


Since 1776 there have been six periods of substantial budget surpluses and significant reduction of the debt. From 1817 to 1821 the national debt fell by 29 percent; from 1823 to 1836 it was eliminated (Jackson’s efforts); from 1852 to 1857 it fell by 59 percent, from 1867 to 1873 by 27 percent, from 1880 to 1893 by more than 50 percent, and from 1920 to 1930 by about a third. The United States has also experienced six periods of depression. The depressions began in 1819, 1837, 1857, 1873, 1893, and 1929. Every significant reduction of the outstanding debt has been followed by a depression, and every depression has been preceded by significant debt reduction. Further, every budget surplus has been followed, sooner or later, by renewed deficits. However, correlation—even where perfect—never proves causation. Is there any reason to suspect that government surpluses are harmful?

From the section, “Conclusions”

It is difficult to take seriously any analysis that begins with the projection that our government will run surpluses for the next 15 or 25 years. Part of our skepticism comes from the inherent difficulty in making projections. Summers and Yellen note, “Today, the U.S. debt held by the public is $1.2 trillion less than was projected in early 1993.” A projection made just six years ago missed the mark by more than a trillion dollars. A few trillion here and a few trillion there can really add up to big errors over a couple of decades.

Even more important, our economy cannot continue to grow robustly as the government sucks disposable income and wealth from the private sector by running surpluses. When the economy slows, the surpluses will disappear automatically—and because the private sector will eventually demand that the government stop draining income from the economy. Tax cuts will be rushed through Congress and the president will put forward spending initiatives.

Finally, surpluses, even if realized, cannot be “locked away” for future use by retiring baby boomers. In every period that government spending falls short of tax revenues, outstanding government debt is retired.

Equivalently, the private sector’s stock of wealth is reduced (since a budget surplus reduces disposable income, and this shows up as a reduction of government debt in private portfolios). There is simply no “surplus” that can be “spent” or even “saved.” Should the government decide to spend more, that simply increases spending relative to taxes and results in a smaller budget surplus. When total federal government revenue falls short of expenditures (including those associated with Social Security), the Treasury will issue new debt to the public to cover the difference. But it must do this whether or not there is a Trust Fund. Neither budget surpluses over the next 15 years nor accounting fictions can change that simple fact. There may be good (noneconomic) reasons for keeping Social Security accounts separately from the rest of the budget, but this should never lead one to believe that a revenue shortfall can be cured by having the government issue IOUs to itself.


The inspiration for this post comes from a January 6, 2020 post in the mainstream economics Reddit group, r/AskEconomics (and reposted in r/mmt_economics). The question is in regards to the picture at the top of the Twitter profile for @fiat_money, as documented here. Both of the above excerpts were submitted as responses in the r/AskEconomics post, but as of this writing neither have been approved by group administrators. This post documents a previous experience I had in this same group.