Money, Banks, and National Debt Unmasked - I

Although we often worry about money, we seldom think about money and its connection to banks until we are short of money or balancing our check books. This series of blogs is intended to bring to consciousness some facts about money and banks that relate to almost everyone’s obsession, national debt.

US dollars enter the economy through the banking system. Money actually has three faces, which are bank reserves, Treasury bonds, and cash. Reserves stay in the banking system and are controlled by the government, treasuries are assets held primarily outside of government, and cash is what we carry around in our pockets or stuff in our mattresses.

We use money and banks every day without thinking very much about what they are or the mechanics of how they work. We know it is usually better to have more money than less and banks are better than mattresses for holding it. Yet we have just had bank bailouts that seem suspicious, we live in fear of deficits and debt that we don’t understand, and we hear of printing money and quantitative easing that appear to go on in the dark corners of the Federal Reserve Bank (Fed).

  

In this and following blogs, I’ll try to tie some ideas together in a way that is readily understood by anyone, who knows how to balance a check book. 

Money is Debt

In an earlier blog, we introduced the idea of money as debt and introduced my former friend Fred. If you, the reader, would like to take a look at that short blog, we’ll wait here until you get back and then recap.

OK, let’s recap. This big bully, Fred, buys things from me with IOUs and then takes some of those IOUs back as a “friendship” tax. What is left I get to keep. We recognized that this is analogous to the way our government buys goods and services and levies taxes.

Sticking with Fred just a bit longer. Suppose Fred does this with other people, so there are lots of people with Fred’s IOUs, and we can trade with each other using those IOUs. Then Fred’s IOUs will have become money. And, instead of trying to pass off these IOUs, I might like to accumulate them. The more Fred owes me the more I am able to buy things with Fred’s money (IOUs), but I’ll need to save some for his damn tax.

One last thing about Fred. He keeps a spreadsheet (a computerized electronic ledger) of the IOUs he has issued. When he gets them back through his coercive taxes or redeems them with dollars, he cancels them from his ledger. So, he always knows how many dollars he must have in the bank ultimately to redeem the IOUs.

Most money is found on a computer spreadsheet

Purposefully, Fred was invented to play a role analogous our own central bank, the Fed. He has introduced us to the following realities:

• The Fed issues IOUs, so the government can buy goods and services from us.
• The government taxes back some IOUs, which decreases their number. 
• If government taxes less that it spends, we get to keep the difference; if it taxes more, we have to get some more IOUs somehow somewhere.
• Taxes make it necessary for us to keep US IOUs, if only to pay taxes.
• We can trade with each other using these IOUs to accumulate more of them and, thereby, increase our wealth.
• Finally, the Fed keeps track of the IOUs it issues on it’s own spreadsheet. These spreadsheet entries are the Fed liabilities that form the basis for our currency..

Fred was not a nice guy to do business with, so we can tell him to shove off. We can’t do the same with our government, because it is empowered by our Constitution (Article 1- Section 8) to coin money and regulate its value.

Fred backed up his IOUs with dollars. When the US was on a gold standard, IOUs were backed up with flecks of gold. Now, our IOUs are backed up with numbers on a spreadsheet. That might bother some, who sensibly ask,  “What is the value of a dollar, if it is backed up only by a piece of paper or, worse, a computer data base entry?”

We’ll consider the value of the dollar in a future blog, maybe the next one.

Conclusion

The story of Fred gives us a very simple basis for understanding how money and our government works. In subsequent blogs, we will try to flesh out some details that might influence our thinking about government fiscal policies.

Related Reading

Look at Myth #6, the others may tantalize you, also.

A more sophisticated discussion than we are offering.

Austerity Experiments Show Neoliberal Failure

As an erstwhile scientist, I like experiments to test theory. Economic theory, however, is generally considered impossible to test, because there is little control of variables. Nevertheless, there have been times in our history when economic theories have been tested reasonably well. One of those times coincides with the present crisis.

Currently, neoliberal orthodoxy is prevailing in most advanced economies in the world. It demands slashing government spending to appease the bond vigilantes, who will, as the story goes, demand high interest rates on government debt refinancing. This adoption of government austerity is the experiment, and the results are coming in. 

In The Guardian, David Blanchflower sums up the current situation in Europe as follows.

“Signs of an improving jobs market in the United States stands in direct contrast to what is happening in Europe. On the same day as the BLS announcement, the European statistical office Eurostat published unemployment rates for the EU27, which showed unemployment increasing on the month in Denmark (7.8%), France (9.8%), Greece (18.8), Italy (8.6%), the Netherlands (4.9%), Portugal (13.2%), Spain (22.9%) and the UK (8.3%), although it did fall in Germany (5.5%). Youth unemployment rates in Europe are especially rising fast and are over 30% in Italy, Portugal and Spain – approximately double US rates.

The evidence from the labor market is also consistent with evidence on consumer confidence, which is worsening in Europe and improving in the US. Eurostat also published its monthly consumer confidence survey, which is falling fast in both the EU27 and in the euro area. In contrast, consumer confidence in the US is rising; for example, the Conference Board's consumer confidence index was up from 40.9 in October, to 55.2 in November to 64.5 in December.”

The UK has done this to itself by voluntarily imposing austerity measures, and David Cameron has said 2012 will be “another tough year.” Apparently unable to learn from its mistakes, the UK has tightened the austerity screws as the situation has deteriorated. The UK has a sovereign currency just like the United States, which gives it policy space to maintain Aggregate Demand with government spending. Fortunately, in spite of strong neoliberal headwinds, the US has managed to support AD enough to keep its nose out of the water. 

The Euro Zone suffers under severe austerity measures imposed by the richest countries, Germany and France. Germany still in great trepidation of another Weimar hyperinflation, which opened the door for Hitler, will not countenance any fiscal expansion in the EZ. As the EZ countries all share the euro as a common non-sovereign currency, none can opt to run deficits without incurring the wrath of the bond vigilantes, who can prey only on those not enjoying sovereign currencies. 

A Modern Money T shirt comments on the effect of the euro on the EZ countries.

The alternative is for the European Central Bank (ECB) to act as the lender of last resort and allow a measure of reflation (a bit of inflation) to counter the devastating deflationary effects of austerity. Germany will not allow it. Either Germany does not understand or does not care that its relative affluence comes at the expense of the peripheral EZ countries. Germany has benefitted from exports to the other EZ countries and, in the process, drained their wealth away. That is what happens to countries with constrained, non-sovereign currencies. They can go broke, they have, and the flawed European Monetary Union is threatened with extinction or long-term hardship for its citizens.

So far, the US has been the counter example in this experiment. So long as it continues to support AD with deficit spending, it might not follow the disastrous european calamity. But, powerful neoliberal forces are gathering to cut the deficit and send us down the road to austerity.

It is ironic that politicians, who usually disdain european policies, would embrace austerity so thoroughly. It is not necessary, it should not happen, and we will look at deficits and debts more closely in the future.

Past Experiments

The best known and most discussed experiment was the recovery from the Great Depression under Roosevelt, which followed the Wall Street crash of 1929 and Hoover’s austerity policies. Government spending and suspension of the gold standard started the recovery, which was topped off with spending for World War II. Further, in 1937, spending was cut under austerian influence, and the economy fell back until spending was resumed.

Again in 1981, the Reagan tax cuts were supposed to bring in revenue via the “trickle down,” supply side theory. Instead, large deficits occurred and stimulated the economy, which set up Reagan very nicely for a second term. Though present-day neoliberals might not agree, Reagan disproved supply side theory and supported Keynesian-like spending at the same time.

Job Creators R Us

We hear over and over: "We can't raise taxes on the job creators." The story is that job creators are business people, who invest in building companies to supply our wants and needs. That it just the old “trickle-down” economics scam. Since it failed miserably in the 1980s, we don't hear about trickle down any more. Now it's “job creators.”

Basically the idea is that by investing in the supply side goods will be more plentiful and prices will come down. This suggests that our dollars will be worth more, so we can buy more and businesses will sell more. That sounds great, but it’s not the way the world works. Business is driven by demand for products not supply of them.

Look at it this way. Would the business people build buggy whip factories? Of course not, because there is no longer any demand for buggy whips. No business person with any good sense will produce a product in the absence of demand. 

Demand sets up a virtuous cycle. It is our demand that leads to production of things for sale to us, and that leads to hiring us so that we have income to buy what we produce. Because our demand drives the economy, we are the job creators.

We do not buy products unless we have or expect to have money in our pockets. For most of us, that money comes from wages earned by delivering goods and services to a customer (employer). From a strictly economic point of view, it matters not whether that customer is a government agency or a private business.

Roughly speaking our income is sufficient to consume all we produce. Or, sadly, we will produce only what we consume. So, economists introduce the idea of Aggregate Demand (AD), the total of what we buy, which is what largely drives our economy. When AD is high, we have high production and low unemployment; when AD is low we produce less no matter what our productive capacity might be and unemployment rises. If AD outstrips our ability to produce, we have inflation. But, with high unemployment and unused facilities, the possibility of inflation is not a problem.

An advocate of Modern Money Theory advocates for Aggregate Demand  at Occupy Wall Street gathering.

When AD is low, as in the current recession, much of our productive capacity, which includes facilities and people, just goes to waste. Both peoples’ skills and equipment efficiency become outdated and unusable. Consequently, our productive capacity is not only wasted; it diminishes, and we pass on to our grandchildren a degraded capacity for them to produce and prosper. 

To keep AD high either government or business must spend on goods and services. This is just simple, basic economics. Some will say that government spending "crowds out" private enterprise. It is true that government spending appropriates resources that might otherwise be used by private industry. However, during a recession, our productivity goes to waste resulting in lost jobs and depressed AD. Then it is necessary for government to step in and pick up the slack in AD by purchasing more goods and services from the private sector. 

Claims of crowding out are based on gold-standard thinking, where government and business compete for a fixed amount of money. Those, who limit government spending that would increase aggregate demand during a recession or its recovery, undermine our productive capacity, impoverish willing and able workers, and leave the country in a worse state for our grandchildren.  

We, the job creators, must demand Aggregate Demand!

Challenges for My Grandchildren

Every generation is faced with unique challenges, and yours, my grandchildren, is no different. However, you have additional challenges, because my generation screwed up. The “Greatest Generation” won World War II, and set up my generation pretty well. We had high productivity, high employment, good wages for everyone, a (then) modern infrastructure for transportation and education. They even developed national parks along with building roads, bridges, railroads, airports and schools. We also inherited Social Security and Medicare as social safety nets. Though some label these benefits of government as “socialism,” I think of them as a helping hand for the unfortunate.

My generation has not been labeled yet, but “Lunkhead” might do very well. We have squandered or are in the process of squandering the legacy of the “Greatest Generation” and pass on to you, their Great Grandchildren, a “bit of a mess.”  Here is a little of what you have to face.

Global Warming is Here

During the 1800’s, scientists understood the greenhouse effect that keeps the earth warmer than the surrounding space. They also suggested that burning fossil fuels would increase carbon dioxide concentrations in the atmosphere, which in turn, would increase the greenhouse effect and warm the earth. Since then, evidence has mounted that human activity is increasing carbon dioxide levels, and the earth is warming as a consequence. 

We Lunkheads have done little but politicize scientific research on global warming and demonize the researchers. The consequences of this failure to act will likely cause you great discomfort. However, mitigating that harm and adapting to warmer climates will provide opportunities.

Higher Education Leads to Prosperity

Any country needs a well educated workforce to compete in the global economy. Early in the twentieth century, an eighth grade education was enough for individual success. Currently, anyone with less than a high school diploma is most likely to be excluded from the workforce. College grads are comparatively well employed.

In recent decades, we have seen domestic businesses move not only manufacturing operations overseas, but also research and development. The former is to be expected; the latter is a condemnation of our educational system and access to it.

We Lunkheads have neither improved the educational process nor made it more accessible to all. Some prospective students wonder if higher education is “worth it.” Perhaps, California’s Proposition 13 in 1978 and its repercussions across the nation were events that undermined state supported education. California quickly lost its preeminence in education and technology. 

Environmental and Financial Regulations are Essential

Energy and food production result in too much pollution in air, land, and waterways. The current neoliberal politics favors the notion that environmental regulations cost too much and that employment opportunities will suffer. They do not mention that technology developed to mitigate pollution creates jobs. 

Much the same can be said for financial regulations. For, at least, the last 30 years financial deregulation has been the norm. Experience shows that free markets, contrary to the neoliberal catechism, do not regulate themselves. Hyman Minsky, an economist ahead of his times, predicted that financial success would create overconfidence and demand for more financial success. Regulations would be relaxed to achieve this success resulting in more frequent and severe business cycles between prosperity and recession. Experience over the past 50 years has vindicated Minsky’s predictions. 

If you continue the neoliberal pattern of environmental and financial deregulation, you can also become a Lunkhead.

Keynes Needs a Revival

To counter natural business cycles, John Maynard Keynes showed that government spending during a recession and relative government austerity during prosperity would maintain a steadily growing economy. The neoliberal economic philosophy begins with a political assumption that an active government is not in the best interest of business. 

This has lead to the Lunkhead assertion that governments don’t count and that austerity leads to prosperity. While that holds for households, it does not hold for a national government that issues and controls its own currency. 

That leads to Modern Money Theory (MMT), which is the most promising post-Keynesian economic theory for our future. However, the neoliberal Lunkheads can’t or won’t understand it, because MMT violates their catechism.

It’s All Up to You

We bequeath to you dilapidated infrastructure, a warming planet, a dysfunctional education system, under-regulated environmental and financial systems, confused economic and political ideas, and last of all, a health profit system that costs twice as much as other countries, yet it covers a lower fraction of the population and has inferior medical outcomes.

Good luck.

PS: You may find it some consolation to learn that, contrary to a prominent neoliberal myth, you won’t need to pay off the national debt; it is not a mortgage.