Thursday, February 16, 2012

Money, Banks, and National Debt Unmasked - IV

In this blog we consider money put into circulation by government spending. 

In the previous blog, we found that bank loans create money “out of thin air” and put into circulation money that is temporary in nature. Without continuous loaning activity the money in circulation would diminish as loans were paid off, which would slow business activity and push the economy toward recession. 
Government Spending Increases Private Financial Assets
The government needs to provision itself with everything from battleships to paper clips and hire the people to operate them. Government contracts with private industry for some things and hires people from the private sector to, among other duties, sweep floors, legislate, mete out justice, and occupy the oval office. 
To pay for these provisions, government creates dollars, which we have seen are just US IOUs. Then it takes back these dollar-denominated IOUs in taxes of one form or another. If the government spends more than it taxes, it is in deficit by definition. And, there is a net flow of dollars from the government to the non-government sector. If the government is in surplus by collecting taxes in excess of spending, there is a net flow of dollars out of the non-government sector to the government sector.
Figure 1, A depiction of major economic sectors involved with money flows. What flows out of one flows into others as a matter of basic accounting.

To be clear, the non-government sector comprises domestic households and  businesses, as well as foreign countries with which we trade. Households provide the people who work in businesses and government. That is to say, households are the ultimate beneficiaries of both business activity and government spending.
Government Spending Increases Bank Reserves
OK, we still haven’t said where these dollars come from. Well, they are just created “out of thin air.” Where else can the government get dollars? No other entity can create them. This is how it is done.
The US Treasury is a bank and pays the government’s bills with checks drawn on its “reserve” account at the Federal Reserve Bank (Fed). The Fed supplies the reserves by marking up the Treasury’s balance. This action is similar to the Fed interaction with a private bank where the Fed supplied reserves to the bank for a loan as we discussed in the previous blog. 
As there is no loan involved in the case of government spending, the reserve supplied is a “free” reserve. It doesn’t go away like bank reserves do when a loan is paid off. 
Having its reserves increased, the Treasury passes the reserves to Tom’s bank, so that bank can credit Tom’s account. As Tom spends his money, those who receive his checks deposit them in their own banks. And, Tom’s checks cause transfer of his bank’s reserves to other banks. The reserves created by government spending remain in the system and just move from one bank to another as checks are cashed. Meanwhile Tom walks away with his merchandise leaving the reserves to others.
The reserves created by government deficit spending are excess reserves, because they never go away. Conversely, government surpluses result in a reserve shortage, as discussed below.
Taxes Reduce Bank Reserves
Hopefully, this idea is now easy to grasp. Taxing is just reverse spending and debits bank accounts just as spending credits bank accounts. Tax payments go to the Treasury’s reserve account at the Fed. Then the Fed uses keystrokes to take back the funds and cancel the liabilities that previously increased the Treasury’s reserves. Taxes, and only taxes, destroy reserves created by government spending.
You might well ask, “Where did the taxes go? Don’t they get saved to make government purchases?” Nowhere and no!  Taxes destroy money. And, logically, that destroyed money had already been created or it wouldn’t be there. Actually, the government has no way to save for future expenses. 
Reserve Excesses or Shortages Clobber the FFR
Both reserve excesses and shortages cause problems for the Fed.

Figure 2, An historic view of the FFR. The Fed increases the rate as inflation threatens and decreases it in recessions.

Remember, the Federal Funds Rate (FFR) is the policy variable the Fed uses, in normal times, to stimulate or discourage bank lending activity. Excess reserves caused by government deficits cannot be resolved by interbank lending. It’s like musical chairs with too many chairs. So banks offer each other lower interest rates in trying to dump their excesses. Consequently, the FFR will default to zero, unless the Fed takes corrective measures.
Exactly the opposite happens when the government is in surplus. There are not enough reserves to go around and banks will bid up the prices (interest rates) trying to meet their needs.
In these currently extraordinary times, the Fed has lost control of lending. The FFR is set to zero, and still there is only anemic bank lending. 
The government creates the money it needs to provision itself and levies taxes to get rid of money. This is a unique capability of a sovereign, unconstrained currency, with a floating exchange rate, and it offers advantages to the government in its stewardship of the currency.
Government spending creates assets in the non-government sector and increases bank reserves net of taxes, which destroy money.
To control the FFR and influence bank lending, the Fed must control the level of reserves in the banking system. That will be the subject of the next blog, the last of this series.
Related Reading

Thanks to Duane again for helpful suggestions.

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