Friday, July 22, 2011

National Debt: What Is It?

Ignorance at the top of our government is appalling. Much time has been wasted by the President and Congress in political posturing around the debt ceiling rather than in meaningful discussion at a time when the economy is in a crisis that no one seems to understand.
In his testimony before the Commission on Deficit Reduction, Prof James K Galbraith made the following comments on June 30, 2010:
“The effect of government check-writing is to create a deposit in the banking system. This is a "free reserve." Banks of course prefer to earn interest on their reserves. Thus they demand a US Treasury bond, which pays more interest without incurring any form of credit or default risk. (This is like moving a deposit from a checking to a savings account.) The Treasury can meet that demand, or not, at its option -- it can permit, or not permit, the stock of US Treasury bonds in circulation to increase.

So long as U.S. banks are required to accept U.S. government checks -- which is to say so long as the Republic exists -- then the government can
and does spend without borrowing, if it chooses to do so. And if it chooses to issue Treasuries to meet the demand, it can do that as well. There is never a shortfall of demand for Treasury bonds; Treasury auctions do not fail.”

His full testimony is an exemplary piece of profound brevity. The essence of how money works in the modern era, since 1971 when the USA went off the gold standard, are contained in the two quoted paragraphs.
As the monopoly issuer of currency, the government can create money, at will, by purchasing goods and services from the private sector. Payments for these purchases result in bank account deposits that, in turn, increase reserve balances at the Fed. Federal taxation removes reserves as bank accounts are debited, which effectively destroys money. Government deficit spending is defined as spending in excess of taxation and results in net assets in the private sector exactly in the amount of the deficit.
So far, we have spoken of spending and taxation resulting in a deficit for the government and increased assets for the private sector. So, where does this debt thing come in? It has to do with those reserves - not foreign bond markets.
Those reserves must be adjusted daily to make sure checks written on one bank and cashed at another will be paid (cleared) promptly. Bank loans also create deposits and reserve requirements. The Fed Funds Rate is the interest rate that banks must pay to acquire required reserves in the overnight market. The Fed adjusts its target funds rate to inflate or deflate the private sector appetite for creating money through bank loans. 
An excess of reserves would drive down the Fed Funds Rate, so the Fed sells Treasury bonds to get rid of excess reserves that accumulate as a result of deficit spending. This is just a matter of moving money from a demand checking account to an interest bearing savings account. Banks are eager to put reserves safely in Treasuries rather than hold low-yield reserve accounts.
But, the Fed has another option. It could just pay its target Fed Funds Rate on the reserve balances to the respective banks. This would eliminate the the overnight funds market, let reserves accumulate, and forego the sale of Treasuries.
Hopefully, this clarifies Prof Galbraith’s statement above. Contrary to popular wisdom, the US or any other country with a sovereign, non-convertible, floating rate currency is not affected by the global bond markets.  The US can meet any debt obligation denominated in its own currency and does not borrow to fund its deficit, it borrows to maintain its target rate in the reserve funds market.
So, we need pay no heed to S&P or Moody’s bond ratings. The Fed sets our borrowing rates. 
The national debt is a optional artifact of the national accounting scheme, which has not changed since we went off the gold standard. Always a nuisance, the debt ceiling, a gold-standard hold over, has become a menace.
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