Fifteen Fatal Fallacies of Financial Fundamentalism

William Vickrey's fifteen fallacies of “financial fundamentalism” — the conventional wisdom of austerity, balanced budgets and inflation-phobia — each paired with his demand-side rebuttal. Adapted from Vickrey (1998), Proc. Natl. Acad. Sci. USA 95, 1340–1347.

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Myth

Fallacy 1: “Deficits are sinful, profligate spending at the expense of future generations — who will be left with a smaller endowment of invested capital.”

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Reality

Reality:Almost the exact opposite.
  • Deficits add to the net disposable income of individuals — government disbursements exceed what it abstracts in taxes and fees.
  • That added purchasing power, when spent, creates markets for private production, inducing producers to invest in plant capacity — the real heritage left to the future.
  • Deficits large enough to recycle the savings of a growing GDP are an economic necessity, not a sin.

Source: Vickrey (1998), “Fifteen Fatal Fallacies of Financial Fundamentalism”, PNAS 95, 1340–1347

Myth

Fallacy 2: “Urging or incentivising households to save more will stimulate investment and economic growth.”

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Reality

Reality:The exact reverse is true.
  • In a money economy, a decision to save is a decision to spend less; less spending means less income for vendors — and so less saving by them.
  • Saving does not create “loanable funds” out of thin air.
  • Investment creates saving, not the other way round. An individual may save more, but only by reducing others’ income and saving by even more.

Source: Vickrey (1998), “Fifteen Fatal Fallacies of Financial Fundamentalism”, PNAS 95, 1340–1347

Myth

Fallacy 3: “Government borrowing ‘crowds out’ private investment.”

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Reality

Reality:The opposite.
  • Spending the borrowed funds generates added disposable income, raises demand for the products of private industry, and makes private investment more profitable.
  • As long as there are idle resources lying around, each additional dollar of deficit can induce two or more dollars of private investment.
  • “Crowding out” is a reaction of monetary authorities, not an economic necessity.

Source: Vickrey (1998), “Fifteen Fatal Fallacies of Financial Fundamentalism”, PNAS 95, 1340–1347

Myth

Fallacy 4: “Inflation is the ‘cruelest tax’.”

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Reality

Reality:The real “tax” of anticipated inflation is small.
  • It is limited to the loss of value on non-interest-bearing currency — yet most transactions use credit and bank accounts, where interest is charged or credited.
  • The genuine damage blamed on inflation is mostly the unemployment produced by inappropriate attempts to control it.
  • Cure inflation by direct means, not by raising unemployment.

Source: Vickrey (1998), “Fifteen Fatal Fallacies of Financial Fundamentalism”, PNAS 95, 1340–1347

Myth

Fallacy 5: “A chronic trend towards inflation is a reflection of living beyond our means.” (Alfred Kahn)

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Reality

Reality:The only time we ever really lived beyond our means was in wartime, when capital was destroyed.
  • We have not lived up to our means in peacetime since 1926 — when full employment meant unemployment around 1.5%.
  • Inflation occurs when sellers raise prices, which they can do profitably when competition is weakened — not because the nation is collectively overspending.

Source: Vickrey (1998), “Fifteen Fatal Fallacies of Financial Fundamentalism”, PNAS 95, 1340–1347

Myth

Fallacy 6: “Unemployment must be kept at a ‘non-inflation-accelerating’ rate (NIARU) of 4–6% to stop inflation rising unacceptably.”

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Reality

Reality:That a fixed NIARU is an unavoidable constraint is doubtful, historically and analytically.
  • The U.S. ran 1.8% unemployment in 1926, West Germany ~0.6% around 1960 — with prices stable or falling.
  • If a NIARU exists at all it is highly variable over time and place.
  • 5% may be barely acceptable; 10%, 20%, 40% among disadvantaged groups is intolerable.

Source: Vickrey (1998), “Fifteen Fatal Fallacies of Financial Fundamentalism”, PNAS 95, 1340–1347

Myth

Fallacy 7: “If governments would just stop meddling and balance their budgets, free capital markets would deliver prosperity on their own (with the aid of ‘sound’ money).”

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Reality

Reality:There is no such market mechanism.
  • Nothing automatically equates planned saving and investment at the level of GDP needed for full employment — achieving it requires deliberate intervention by the monetary authorities.
  • A balanced budget tends to stop growth in nominal GDP altogether; in the presence of inflation it leads to a downturn in real GDP and rising unemployment.

Source: Vickrey (1998), “Fifteen Fatal Fallacies of Financial Fundamentalism”, PNAS 95, 1340–1347

Myth

Fallacy 8: “If deficits continue, debt service will eventually swamp the public finances.”

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Reality

Reality:Reasonable scenarios show a negligible or even favourable effect on the fisc.
  • With nominal GDP growing ~6% and interest at 8%, 6% of interest is financed out of the growth in the debt itself — leaving only ~2% to meet from current taxes.
  • Income tax on the interest and savings on reduced unemployment benefits cover much of even that.
  • A full-employment economy with a $15tn debt is far easier to handle than a depressed one with a $5tn debt.

Source: Vickrey (1998), “Fifteen Fatal Fallacies of Financial Fundamentalism”, PNAS 95, 1340–1347

Myth

Fallacy 9: “The overhanging burden of the increased debt cancels out the stimulative effect of the deficit.”

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Reality

Reality:This sweeping claim depends on a failure to analyse the situation in detail.
  • The “Ricardian equivalence” thesis crucially depends on which taxes are expected to finance the debt service.
  • With a sales or value-added tax as the mainstay, a deficit has a fully stimulating effect — through the increase in the aggregate supply of assets — with no depressing effect on capital values.
  • The “burden” does not displace the stimulus.

Source: Vickrey (1998), “Fifteen Fatal Fallacies of Financial Fundamentalism”, PNAS 95, 1340–1347

Myth

Fallacy 10: “The value of the national currency in foreign exchange (or gold) is a measure of economic health — a ‘strong’ currency is something to be proud of.”

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Reality

Reality:Freely floating exchange rates are simply the means by which countries adapt to differing price-level trends — not a scoreboard of health.
  • Fixed or narrow-band rates can be held only by efficiency-impairing tariffs or by imposing needlessly high unemployment (as the Maastricht rules imply).
  • Jingoistic pride in a strong currency, or in the cheaper imports it buys, is misplaced.

Source: Vickrey (1998), “Fifteen Fatal Fallacies of Financial Fundamentalism”, PNAS 95, 1340–1347

Myth

Fallacy 11: “Exempting capital gains from income tax will promote investment and growth.”

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Reality

Reality:Any special category of income invites the sorcerer’s-apprentice of tax avoidance.
  • Defining what counts as a “capital gain” spawns a thousand avoidance schemes and a techies’ industry to exploit them.
  • Personal income tax on gains is levied at or below the market and has little effect on the funds available for capital formation.
  • Far more effective: reduce or eliminate the corporate income tax, which sits above the market.

Source: Vickrey (1998), “Fifteen Fatal Fallacies of Financial Fundamentalism”, PNAS 95, 1340–1347

Myth

Fallacy 12: “Debt will eventually reach levels that cause lenders to balk, with taxpayers threatening rebellion and default.”

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Reality

Reality:This fear comes from observing crises in countries with debt denominated in a foreign currency.
  • Where the debt is in the domestic currency, there can be no question of the government’s ability to make payments when due (if necessary in a currency devalued by inflation).
  • Nor will domestic lenders balk, so long as the debt only fills the gap of excess private asset supply over private demand.

Source: Vickrey (1998), “Fifteen Fatal Fallacies of Financial Fundamentalism”, PNAS 95, 1340–1347

Myth

Fallacy 13: “Authorising income-generating budget deficits results in larger, more extravagant and wasteful government spending.”

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Reality

Reality:The two issues are quite independent.
  • A government could run a deficit with no activity beyond issuing bonds, paying out old-age pensions, and levying taxes sufficient only to cover net debt service.
  • What activities are worthwhile for government to undertake is a totally separate question from balancing the economy at full employment.

Source: Vickrey (1998), “Fifteen Fatal Fallacies of Financial Fundamentalism”, PNAS 95, 1340–1347

Myth

Fallacy 14: “Government debt is a burden handed on from one generation to its children and grandchildren.”

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Reality

Reality:Quite the contrary, in generational terms.
  • The debt is the means whereby working cohorts — kept fully employed — earn and invest in the increased supply of assets, providing for their own old age.
  • In this way the children and grandchildren are relieved of the burden of providing for the retirement of the preceding generations.

Source: Vickrey (1998), “Fifteen Fatal Fallacies of Financial Fundamentalism”, PNAS 95, 1340–1347

Myth

Fallacy 15: “Unemployment is not due to a lack of effective demand — it is ‘structural’, ‘regulatory’ or ‘voluntary’.”

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Reality

Reality:At current demand levels, a large share of the unemployed are ready and able to take the kinds of jobs an increase in demand would open up.
  • It is a game of musical chairs: if 200 passengers rush for 150 seats, getting there early helps one traveller but not the queue as a whole.
  • Training and threats merely move selected people up the queue — without reducing its length. Only added demand creates the missing chairs.

Source: Vickrey (1998), “Fifteen Fatal Fallacies of Financial Fundamentalism”, PNAS 95, 1340–1347

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