In 2004 former Treasury secretary Paul O’Neill, fired from the cabinet in
2002, released his revealing exposé of the early Bush administration. It contained a nugget that haunted the economic policy community. In November 2002 O’Neill tried to warn Vice President Dick Cheney that the surging “budget deficits . . . posed a threat to the economy.” Only for Cheney to cut him off with the following remark: “You know . . .Reagan proved deficits don’t matter.”

Crashed: How a decade of Financial Crises Changed the World, Adam Tooze (2018)

Do deficits matter? What is inside and outside money? How is the difference between inside and outside money related to the question of whether deficits matter or not?

While deficits allow private institutions to accumulate safe and liquid claims on the government¹, it also provides flexibility to governments in its policy objectives of development and growth. However, deficit spending needs to be funded through sale of government bonds, which although among safe assets, can become volatile if markets think the state finances are in poor shape, as was feared by the Hamilton Project.² It may be the case with emerging markets or even markets dependent on foreign currencies for funding but this certainly wasn’t the problem with US deficits as Europe and Asian banks and financial institutions used looked for dollar-denominated debt.

Inside money is an asset which is someone else’s liability within the same horizontal level in the monetary hierarchy while outside money isn’t.³ The latter is a liability of someone at a different level in monetary hierarchy. So, outside money, say central bank money, is a net asset is a net asset for the domestic banks or US$ is a net asset for other central banks.

O’Neill argued to Cheney that surging deficits may push bond vigilantes to increase interest rates worsening the fiscal situation of US government. However, he missed the point that US$ denominated debt was the most preferred outside money (asset) for all major banks and financial institutions. So, what appeared to be an oversupply of US debt to the Rubinite democrats was in fact a shortage in demand of the safest asset possible in the global financial network. So, deficits did matter. Just not in the way that the deficit hawk among American elites had assumed it would. 

Increased savings of the emerging global rich individuals, corporations and funds pushed them to look for relatively liquid, high-yielding, safe asset. While transactions between banks and funds in wholesale funding markets was of asset-backed commercial paper or through repo (ABCP and private MBS – inside money among banks), the investment banks had to keep government bonds (outside money for them) on their balance sheet as capital, the requirement of which changed with market confidence in the banks’ other assets (MBS – inside money). The deficit hawks who were concerned about a sharp rise in rates were surprised that the rates were low – fed by the demand for Treasurys and GSE-debt. So, the inside money created by investment banks (MBS, CDO, ABCP etc.) were supposed to be backed by outside money, US debt which market couldn’t get enough of. So, deficits in the US case, as Cheney pointed out, didn’t matter as there was no other ‘outside money’ to constrain it.

However, in other countries where outside money is a major source of funding for deficit spending, the national government might be forced to address the concerns of the bond market through ‘fiscal management’. And if the outside money includes money from foreign investors (say in US$ – outside even the control of national central banks), then the fiscal deficits matters even more and this outside money further constrains the fiscal space.

References:

1. Wray, L. (2014). Outside Money: The Advantages of Owning the Magic Porridge Pot. Levy Economics Institute, Working Paper 821
2. Tooze, A. (2018). Crashed: How a decade of financial crises changed the world. Penguin.
3. Lagos, R. (2006). Inside and Outside Money. Federal Reserve Bank of Minneapolis Research Department Staff Report 374