Wednesday, April 27, 2011

Borrowing Does Not Fund the Deficit

There is a persistent misperception that the US must borrow to fund its deficit. In a previous post, Gold is Gone, we pointed out that economic rules have changed since we went off the gold standard in 1971. 
The US now has a sovereign, floating exchange rate, fiat currency that is actually created out of thin air by government spending to acquire goods and services from the private sector (firms and households). Taxation takes money from the private sector and destroys it. If taxation does not equal what was spent, we buy or sell bonds according to whether we are in surplus or deficit, respectively. Accordingly, that leaves the private sector with less or more wealth in savings. This might leave the impression that taxes and borrowing enable spending. Let’s look more closely.
Government spending is accomplished by depositing money in a recipients bank account. This deposit causes an increase in the bank’s reserve requirement.
Every bank has a reserve account at the Fed, which requires them to keep some fraction of their deposits in these accounts.  For big banks this minimum is 10%. Also, the banks must keep enough in their reserve accounts to clear the checks presented for payment on any day. Banks earn only about 0.25% interest on these accounts; before 2008 it was zip.
As a instrument of policy, the Fed tries to control demand for loans in the private sector by controlling the overnight Fed funds interest rate. This is the rate at which banks can borrow money to cover loans made at profitable rates.
Because they make little profit on excess reserves, banks try to keep them at the required minimum. A day's activity at any one bank can leave it with an excess or a shortage. Overnight the banks have a scramble to acquire needed reserves or dump excesses, which they do by loaning funds to one another in the money market.  
If the government is running a deficit, there will usually be excess reserves in the system, because deficit spending puts assets into the private sector. There is no way that the banking system can, by itself, get rid of excess reserves, so the forces of supply and demand will drive the interest rate on reserves to the minimum rate. To keep the overnight rate up, the Fed drains excess reserves by selling bonds at somewhere near its target rate. Buyers will be eager to buy bonds having yields better than the minimum rates, so bond sales never fail.
We do not borrow to fund the deficit; we sell bonds to maintain the Fed funds rate. That is a big difference between our floating rate currency and that of fixed rate currencies like those of Greece and Ireland. Such countries are vulnerable to default on their securities and face high interest rates in the global market. We are not vulnerable to default, because we can always meet commitments made in our currency.  That is, unless we do something politically stupid like not raising the debt ceiling, an archaic rule left over from the gold-standard days.
The above is for normal times. Currently, banks are reluctant to lend and the private sector would rather save than borrow. Consequently, the Fed funds rate sits at the minimum. The Fed can’t control something that isn’t happening.

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