Austerity is no answer!

The Peter G Peterson Foundation, in a futile attempt to reduce federal deficits, is investing in a big program to promote austerity, which demands reduced federal government spending. Unfortunately, the program has a high probability of being implemented, because many pundits, politicians, and a few economists seem to like the idea.

Austerity deprives the private sector of dollars, which reduces household demand for products, which, in turn, reduces the incentive of private industry to invest. This fatal attraction to austerity during recovery from a depression has afflicted the euro zone and the misdirected economies of Britain, Australia, and Japan. We don’t have to repeat those mistakes, and we must not.

The allure of austerity comes from the old, gold-standard view of money. In this old view, before government can spend, it must first acquire money from the private sector through taxation or borrowing.

From this gold-standard regime came the present-day myths, "Government must balance its budget just like a household," “national debt is a burden on our grandchildren,” and “international bond markets will not want to buy our debt.”

The new way money operates in our economy began when we went off the gold standard, which was finalized with the demise of the Bretton Woods Agreement in 1973. The modern US dollar is fiat money with a floating, foreign exchange rate. As a consequence the real value of the dollar depends not on the arbitrary value of a metal dug out of the ground but on our nation's productive output. That is something that can neither be taken from us nor given to us. It depends on our own hard work and stewardship of our economy. 

Dig money from the ground? Better to use the effort to build a school or bridge.

The modern dollar changes everything. A sovereign country that issues its own fiat money with a floating exchange has no economic reason to tax or borrow from the private sector to acquire money. Instead, government creates the dollars necessary to purchase goods and services from the private sector. These purchases put dollars into the private sector by the amount of government spending minus tax revenue. Yes, deficit spending increases the financial assets of the private sector exactly to the dollar of the deficit. This, of course, raises the question of why we tax at all.

Taxation creates demand for money issued by the government, takes dollars out of the private sector to avoid inflation, and provides a means of wealth redistribution from the rich to the poor.

In what is called borrowing, government sells Treasury bonds to provide a means for risk-free preservation of private financial assets and a way for the government to balance reserves in the banking system. Banks gladly use their reserves to buy bonds, which provide greater interest. The process is just like a household taking money from a checking account to buy a Certificate of Deposit.

Our US economy, measured by gross domestic product (GDP), depends on the sum of household consumption, business investment, government spending, and net exports. As we are a net importer, net exports is a negative number. So, consumption and investment must usually carry the load, but each depends on household willingness to go buy things. Business will not invest more in the means of production unless there is consumer demand for things, and households will not buy things unless they have money to spend.

Contrary to common assertions, in the absence of household willingness to buy things, no amount of lower taxes or reduced regulations will induce business to invest. Household demand drives GDP.

In an economic downturn, such as we have experienced since 2008, when consumers are cautious about spending and business investment is waiting for customers to return, fiat money provides a solution.

The federal government can deficit spend to maintain GDP and increase employment by investing in the future. Such investment might include infrastructure (transportation, utilities, and education), new means of energy production, and scientific research and development. The government can never spend too much money as long as there are unemployed people and equipment that can be put into  production.

Those who promote austerity assert that federal deficits will increase interest rates and burden our grandchildren with increased national debt. They are wrong.

Interest rates are set, not by the “market,” but by the central bank in any sovereign country with floating-rate, fiat money. Our grandchildren will inherit both the interest-bearing bonds that constitute the so-called "national debt," and the means of production embedded in a modern infrastructure. 

Austerity reduces GDP, increases unemployment benefit costs, and increases the deficit by reducing employment of our productive resources. We should not keep any resources on the sidelines; we need to keep them all working and producing.

Related Reading:
Pete Peterson Has Won
Lerner on “The Burden of the National Debt”
Unemployment is a misallocation of resources

Our Grandparents Knew Better

We see the results: high unemployment, the collapse of the middle class, more children in poverty, outrageous wealth inequities, declining opportunities for both jobs and education. We are experiencing the result of four decades of conservative, neoliberal domination of our economic agenda that has been advanced by both political parties. After simmering for years, the breakout came when Reagan declared, "Government is not the solution; government is the problem." He was wrong - dead wrong.

Our grandparents understood what we have forgotten. They understood the role of government in the economy. And, they understood that the economy is not all about money; it is about productive capacity. They understood that government spending puts financial assets into the private sector. So, government can spend in a manner that is counter-cyclical to the business cycle to maintain a healthy economy.

In recent decades we have become burdened not with unsustainable public debt but with the myth that government finances are the same as those of the household. Where once we could afford, as a nation, anything we could actually do (moonshot); now we can afford very little, because we don't have enough money, which is asinine. We think that we can only do what we already know how to do (drill, baby drill). Then we must relax environmental standards and financial regulations to make our efforts more profitable. We fear opening new horizons, because we can't afford them.

We have been duped! Our elder statesmen tell us we are burdening our grandchildren with debt, and that increasing deficits are caused by too much government spending. The truth is different. Government spending enriches our grandchildren and deficits are caused by too little production. Thus, we have been frightened into accepting economic conditions contrary to our own best interests, but quite acceptable to the elite 1%.

The scales will be tilted toward the elite 1% until we citizens of a great nation realize the following simple truths that our great productive capacity affords us.

    •    We can assure a decent standard of living for our elderly.
    •    We can provide health care for all our citizens so that no family need become impoverished by adverse health issues.
    •    We can educate our youth to provide a highly capable workforce in support of an entrepreneurial society.
    •    We can assure opportunities and prosperity for all industrious citizens.
    •    We can regulate our financial institutions so that they can not "stack the deck" against their own customers.

In short, we can do anything we put our minds to once we again accept the idea that we are a "can-do" society. We have lapsed into a "can't-do" society, because we have been duped by false economic myths perpetrated by a wrongheaded, neoliberal economic ideology. 

Related Reading
New Sense - Common Sense

The Deficit is Uncontrollable!

There is a very important macroeconomic accounting relationship that is so simple it boggles the mind. Yet many economists disregard it or think people are too simpleminded to understand it. With understanding we all might become better informed than most pundits and politicians.

The accounting relationship merely states that if any country has a foreign trade deficit, which means that it imports more than it exports, that country consequently will have a matching deficit in its domestic economy. This happens because imports cause money to flow from domestic bank accounts into foreign bank accounts.

Accounting matters.

Someone might reasonably ask, “So what?” The answer lies in realizing that the domestic economy comprises a public sector and a private sector. So, if a foreign trade deficit exists, one or both of the domestic sectors will incur a deficit. We discus below that the public deficit depends in large part on how much the private sector decides to save and import. The deficit can not be determined beforehand.  Accountants can always figure out what happened but not what will happen, because government has no control over private decisions.

When a sector is in deficit, that sector incurs increasing debt. But, there is a significant difference between the debt incurred within the private sector and and that in the public sector (federal government).  Increased debt in the private sector means increased bank loans. Deficits in the public sector contribute to the so called “national debt,” which results in more treasury holdings, which are risk-free savings instruments, in the private sector. 

In the late 1990’s, our government ran surpluses that most people thought was a good outcome. They didn’t realize that, if the public sector ran a surplus, the private sector would consequently have to run a deficit. In fact, there began a decade-long period of increasing private debt due to increasing foreign trade deficits and inadequate public deficits.

Of course, as it turned out, the mounting private debt exacerbated by unscrupulous financial practices all came to an abrupt halt at the start of our current economic crisis. Since early 2008, the private sector has been saving and, therefore, has been in surplus like never before. Consequently, the public sector is forced to incur the debt necessary to match the foreign trade deficit as well as the extraordinary private saving. Private decisions to save and to import can affect the deficit more than public policy. Those private decisions, like buying foreign cars or saving more of discretionary income, which are beyond government control in a free society, make the federal deficit impossible to control.  

Because the deficit is uncontrollable, it is bad policy to attempt to control it by reducing public spending, which only serves to increase unemployment that, in turn, leads to higher public deficits. We need something like a speedometer on a car that allows us to monitor the performance of the economy. Unemployment and productive capacity work together as such a speedometer, because unemployment and productive capacity are basic to both inflation and GDP growth. 

As a matter of policy, we should try to control what we know how to control instead of something that is inherently uncontrollable. The need to balance the federal budget is a myth promoted by those, who benefit from private sector debt. We need less not more private debt to benefit the whole economy.

When government spends responsibly by investing in job creation programs like infrastructure modernization, public education, and science and technology research, it can reduce unemployment and grow GDP while at the same time improving the public good. The deficit will then take care of itself by reducing its size relative to GDP. 




Thanks to Duane for help on this post.

Bill Clinton is still bragging about his surpluses!

Because presidential elections turn on the economic condition of the country, we might expect candidates to know something about the subject of economics. Apparently, neither they nor their advisors know very much.

As lovable Bill brags about running government surpluses, we might ask a couple of obvious questions. 

Why should the government run a profit?  And, from whom does that profit come?  That profit comes from household money. It doesn't make sense for the government to compete with private industry for profits, does it?

It makes more sense, particularly during recessions, for the government to run deficits, which put financial assets into households. That helps maintain household spending, which is the main driver of our economy.

Bill Clinton should stop bragging about his surpluses, they did more harm than good. Unfortunately, Obama and Romney both fail to see the inevitability and virtue of deficits.

Unemployment is a misallocation of resources

Unemployment is wasted production, and it mounts into the trillions of dollars. Our economy is about production not money. The US government can afford to buy anything for sale in US dollars, because it is the source of US dollars. That is to say, it can buy anything that the country can produce. 

If private industry can’t or won’t use our nation’s full productive capacity, it costs nothing for the government to make use of those resources, especially the unemployed to produce goods and services of value to the nation. Utilization of unemployed resources pays for itself.

Back in 1933, three years before I was born, Mariner Eccles, a successful capitalist of that time, had the vision that we lack today. It was the vision that led the country out of the Great Depression despite the cries of the ultra-conservatives, who counseled austerity. Here is a quote from his testimony before the US Senate in 1933.

“Before effective action can be taken to stop the devastating effects of the depression, it must be recognised that the breakdown of our present economic system is due to the failure of our political and financial leadership to intelligently deal with the money problem. In the real world there is no cause nor reason for the unemployment with its resultant destitution and suffering of fully one-third of our entire population. We have all and more of the material wealth which we had at the peak of our prosperity in the year 1929. Our people need and want everything which our abundant facilities and resources are able to provide for them. The problem of production has been solved, and we need no further capital accumulation for the present, which could only be utilised in further increasing our productive facilities or extending further foreign credits. We have a complete economic plant able to supply a superabundance of not only all the necessities of our people, but the comforts and luxuries as well. Our problem, then, becomes one purely of distribution. This can only be brought about by providing purchasing power sufficiently adequate to enable the people to obtain the consumption goods which we, as a nation, are able to produce. The economic system can serve no other purpose and expect to survive.”

(emphasis added)

Present-day politicians seem to have lost faith in our country. The deficit hawks are either idiots or liars. We have put the unemployed to work before, incurred large deficits and debt, and we prospered. Those who say it is not possible now have lost faith in our country’s ability to innovate and produce.

From Krugman, we have the following graphic revealing that at a time when the government should have been hiring, it was increasing unemployment by laying off government workers. My take is that Obama was too compliant in the face of the Tea Party, which knows nothing of economics but a lot about emotional manipulation of the uneducated, which is politics.

The blip at 16 months in the Obama curve is census hiring. Government hiring includes federal, state, and local. While the Obama administration tried to support state and local government, he was effectively outsmarted by the Tea Party.

This is not to give Obama a pass on this horrendous result. It was he, who appointed a Deficit Reduction Commission co-chaired by two notorious deficit hawks. Ultimately, the Commission failed to produce a report. However, some people often refer to the Commission Report, which is merely the opinion of the co-chairs, Simpson and Bowles. 

Where Obama has acceded somewhat slowly to the demands for austerity, we can expect Romney to go full speed ahead, because Paul Ryan will be whispering shouting in his ear. 

It is frustrating to see our leaders cower before the future instead of striding boldly towards a well-educated, highly productive nation.

Related Reading

Testimony of Marriner Eccles to the Committee on the Investigation of Economic Problems in 1933

Mariner Eccles Full Testimony, Feb. 13 - 28, 1933

The Most Important Macroeconomic Relationship

In 1999, the late Wynn Godley (1926-2010) predicted the great financial crisis. His insight into the economy was through the lens of the three-sector financial flow accounting discussed in the last blog. 

We can state the relationship in words as

Public Net Income + Private Net Savings + Net Foreign Imports = 0.

Godley noticed that with a perennially positive import balance and the then current government surpluses, which politicians and pundits applauded, the private sector savings would have to be negative. That is, the private sector was borrowing to finance imports and the public surpluses. Only a few economists noticed this conundrum, and Godley, a proponent of the Financial Sector Balance (FSB) accounting relationship, was among the first. 

At the Bureau of Economic Analysis (BEA) our nation’s bookkeepers compile piles and piles of data in their National Income and Production Account (NIPA) Tables. From these tables we can find the data series that illustrate the FSB relationship including what Godley saw and foretold. An FSB history is shown in Figure 1, where there are several characteristics to note. 

Figure 1. Financial sector balance flows add to zero at each point in time in accordance with the three- sector relationship.

• When private saving increases (blue line) public deficit increases (red line). 
• The oil crises that caused high oil prices in the 1970s resulted in a recession characterized by unusually high private saving and increased public deficits. Such is the signature of recessions.
• During the 1980s, the Reagan tax cuts in 1981 increased public deficits contrary to “supply side theory.” In any event, the recession of 1982, possibly triggered by tight money policies, dominated the economy. The stock market crash in 1987 was laid at the feet of high deficits though high imports contributed to the deficit.
• H W Bush promised in 1988 to hold the line on taxes, just read his lips. But, deficit hysteria put pressure on him to do something. In 1990, he reached a compromise that resulted in some tax increase. Then the recession of 1992 took over, private savings and deficits increased in unison and Bush lost reelection.
• During the Clinton years, 1992-2000, a combination of tax increases and spending restraint produced both a public surplus and competition between Democrats and Republicans to take credit for what was interpreted to be a successful budget outcome.

We want to focus on what Godley noticed. As the public deficit was declining and becoming a surplus private saving was diminishing and becoming borrowing instead. Clearly, obsession with the deficit distracted our leaders from what was going on in the private sector.

It might have been worse but for the Bush tax cuts that allowed the deficit to increase again and gave the private sector some relief. But, it was too late. The housing crisis of 2007 took over the whole show. In a resounding example of Keynes’ “Paradox of Thrift” the private sector stopped spending, unemployment increased, automatic stabilizers (food stamps, unemployment insurance) kicked in and the deficit exploded.

Figure 1 gives us flows into and out of the sectors not the stock of debt or saving. It would be appropriate to ask how high did the private debt go and how does it compare to the public debt that everyone seems to be worried about? 

To answer those questions, we call upon Prof. Steve Keen of the University of Western Sydney, Australia, where he is noted for his mathematical modeling of financial instabilities. Figure 2 is taken from Keen’s presentation at the Berlin 2012 INET (Institute for New Economic Thinking) Conference.

Private debt, which is a burden, far exceeds public debt, which is a private asset.

Once again the data are clear. Concentration on public deficits and public debt distracted us from noticing the accumulation and huge build up of private debt. After the Great Depression in the 1930s, regulations were put in place to prevent financial instabilities. But, over the last four decades, Presidents, both Republican and Democrat, have presided over deregulation of the financial markets with the results we experience today. And, still we hear cries for more deregulation, and another Democrat President seems ready to oblige.

It wasn’t the public sector that got into debt trouble and couldn't pay its bills, it was the private sector. So, we might conclude; it’s the private sector debt, stupid!!

Related Reading

Derivation of the most important macroeconomic equation

The Sector Financial Balances Model of Aggregate Demand—Revised

Why MMT is Like an Autostereogram

Deficit! It's Not a Choice.

It's all in the accounting. Paul Ryan, US House of Representatives Budget Committee, Chair, can't just decide to cut the deficit. There is more going on than he seems to understand. However, that didn't keep him from being honored last year by the deficit hawks at the Peterson Institute which gave him a "Fi$cy Award" for his fiscal responsibility. Apparently his budget for this year, which passed the house yesterday, is an attempt for a repeat award, although he still hasn't made clear where he would make his draconian cuts. But, he damn well intends to cut the deficit. We will show he can't do that.

All we need to do is look at the way dollars flow from one economic sector to another. Let's start with the domestic and foreign sectors. When we import from another country we give that country dollars. That is, dollars are debited in US accounts and credited to foreign accounts. Debits decrease account balances and credits increase them. Accounting dictates that the sum of debits, which are minuses, and credits, which are pluses, must add up to zero.

We could write a simple equation like this for any period of time, say a quarter or a year.

Domestic Balance + Foreign Balance = 0

When we net import, the Foreign balance is positive and the Domestic balance is negative by the same amount. If we net export the reverse is true. As a matter of fact, the US has been net a importer for many years and will remain so for many more.

It is informative to decompose the Domestic sector into a Public (Government) sector and the domestic Private sector, which includes households and businesses, as shown in the Figure 1. 

Figure 1. Three sectors comprise global economic activity as seen from the US.

It might not be obvious at first blush, but the Public sector has no people. It is just buildings, books, laws and, let us not forget, a Constitution. The Public sector hires people (janitors, justices, soldiers, and President) from the household sector to acquire goods and services. In so doing dollars flow from the Public sector to the Private sector and, possibly, to the foreign sector.

Also, for completeness we mention, firms hire people from the household sector. But, these interactions do not cause dollars to flow between the colored sectors. It follows upon a bit of reflection, that all income flows to households (in wages, dividends, and interest), and households pay for everything. Household consumption compensates firms for all costs of production from taxes, to wages, to raw materials and, of course, profit.

All economic activity takes place within these sectors, which form a closed system, at least until we engage in interplanetary commerce. All intersector economic activity causes dollars to move between sectors, and at the end of the day, the sum all debits and credits will  be zero.

Now, we can expand the Financial Sector Balance (FSB) equation to

Public Balance + Private Balance + Foreign Balance = 0

Figure 2. defines the terms in the FSB equation.

Figure 2

In this equation, the Public Balance is taxes net of public (government) spending, deficits are minuses, surpluses positive. Private Balance deserves quite a bit of attention, which we will reserve for another day. Today, we will note that the Private sector will net save or borrow. If it saves, the wealth of the sector will increase. Net borrowing will increase net private indebtedness, which in our analysis would be net deficit. So, with a positive foreign balance, at least one of the Public and Private sectors must be in deficit.

As a matter of history, the Private sector started a borrowing (deficit) binge in the late ‘90s. Remember the fabulous Clinton-Gingrich surplus? The binge continued until the crash in 2008 at which time the private sector began a saving binge that continues today. With the Foreign and Private balances in surplus the public balance must be in deficit. 

Our FSB equation is an accounting relationship not a law of physics. It doesn't predict what will happen, it just reports what happened. Whether or not the public balance is in deficit or surplus depends on more than government decisions. It depends, also, on people's decisions in the aggregate to import, like shop at Walmart or buy foreign cars, or to save in hard times more than they would in good times.

Because of these private-sector decisions the deficit is not a choice; it is a result. Paul Ryan simply doesn't know what he is doing.

Related Reading

I Was Wrong About Paul Ryan

Representative Ryan Calls for Eliminating Park Service, FDA, Justice Department, and Just About Every Thing Else in Government and Media Don't Notice

The Iron Grip of Accounting Identities

Money, Banks, and National Debt Unmasked - V

In this blog we discuss what constitutes the “national debt” and how we come by it. It is widely misunderstood and is not nearly as important as is, say, unemployment.

National Debt? We Don’t Need It

In the first blog of this series, we reminded ourselves that all money is debt. It follows that when money is created by either printing it on paper or with computer keystrokes, debt is issued. There is no necessity for government to issue debt again by selling Treasury bonds. No country that has a sovereign, non-convertible, floating rate currency needs to sell bonds to fund its spending and thereby create a national debt. However, old gold-standard rules, procedures, and laws stand in the way of other rational options.

If one party is in debt, another party must be a creditor and hold the corresponding asset. A government debt is a non-government asset. The national debt clock could just as well be called the private Treasury savings clock. And, the proportionate distribution of that debt to families could be called family savings. Ironically, if this reality were understood, families would ask, ”Where is our share?” They would find those Treasuries mostly in the pockets of the wealthy.

Figure 1. Our National Savings Clock

If we don’t need it and don’t like it, why do we have a national debt?

The Fed Buys and Sells Treasury Bonds to Manage Bank Reserves

In the previous blog, we learned that without some way to manage day-to-day fluctuations in reserves, the Fed would be unable to manage the FFR (Federal Funds Rate). 

Government deficit spending results in excess reserves, and government surpluses bring about reserve shortages. To drain excess reserves the Fed sells Treasury bonds from its portfolio to commercial banks. This is equivalent to Anne buying a CD (Certificate of Deposit) with excess funds in her checking account. The CD allows her to earn a bit more interest on her funds. Banks are happy to buy Treasuries for the same reason, because they get more interest when they convert their excess reserves into Treasury bonds.

The Fed responds to a government surplus by purchasing bonds from the banks, which converts their bond holdings back into reserves to remove the shortage. This does not add to the “national debt,” it’s like depositing the funds from a CD back into the checking account.

Most importantly, we notice that these bond operations for managing reserves are carried out within the banking system. There are no foreign bond buyers required. The rating services of S&P, Moody’s, or Fitch have nothing to do with internal banking operations and are irrelevant. The Fed sets the interest rates not the external markets.

These bond “purchases” and “sales” are just a matter of moving numbers around on the Fed’s spreadsheet. The New York Federal Reserve Bank is responsible for conducting these Open Market Operations. You can read all about draining reserves at the NYFed website.

Other Options are Available

Bond sales and repurchases are only one way to manage bank reserves. Some ranking Fed officials have recommended that rather than sell bonds, the Fed could just pay the target FFR on the reserves held by the banks (see here and here). This would give the Fed precise control of the FFR and would be a boon to the banks rather than the current holders of Treasuries. 

It probably won’t happen, because it would pit the rich against their banks, which might be fun for the 99% to watch. Reserves would accumulate to large numbers in the banking system with no ill effect.

Another method, employed by Japan, would be to hold the FFR at zero and let the reserves accumulate. That would also be a political problem, because many of the rich and some, who hold bond mutual funds, want to have a base of risk-free, interest bearing bonds.

Quantitative Easing

Currently unable to influence bank lending by lowering the FFR, the Fed is paying 0.25% interest on reserves, which is the FFR. The Fed has purchased bonds under the quantitative easing programs, QE1 and QE2, in a misguided effort to encourage a little inflation. All that has happened is an extraordinary increase in excess reserves as seen in Figure 2. Although some claim this is inflationary “printing” of money, we know these reserves are tucked away in the banking system and will not spill out into the economy. 

Figure 2. Accumulation of excess reserves as a result of quantitative easing. It's dramatic looking but of little significance.

Actually, the bond purchases under QE are somewhat deflationary, because interest generated by the bonds is paid back to the Treasury to the tune of $50 to $80 billion a year, rather than going into the private sector. This is interest income that was not available for spending in the private sector.

How About Passing the National Debt to Our Grandchildren?

Please do! If I leave a house and mortgage to the kids, they will have to pay off the mortgage to keep the house. If I pass on to them some Treasuries, they will have excellent, risk-free assets that pay income or can be used as collateral for a loan. 

Most of the interest the Fed will have to pay goes right back into the economy. That the interest is paid primarily to the rich is a political rather than an economic problem.

Conclusion

Our national debt is the result of the way government has chosen to manage excess bank reserves. The issuance of debt to manage bank reserves, is optional. 

The government’s debt, according to fundamental accounting, represents assets in the private sector, not intergenerational debt. Our grandchildren are enriched rather than burdened by those assets. 

Quantitative easing, which increases reserves, is not inflationary.

Related Reading

Building bank reserves is not inflationary

Yes, Deficit Spending Adds to Private Sector Assets Even With Bond Sales

Deficit spending 101 – Part 3

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. 

Conclusion

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

Modern Monetary Theory—A Primer on the Operational Realities of the Monetary System

Why budget deficits drive private profit

The Case Against Intergenerational Accounting:

Thanks to Duane again for helpful suggestions.

Money, Banks, and National Debt Unmasked - III

This blog will look at how bank loans inject dollars into the economy. Anyone, who has had a mortgage, car loan, or credit card knows something about debt. With that in mind, it may seem strange that we can’t understand national debt without knowing about banks and the mechanics of bank loans.

Banks Create Money out of “Thin Air.”

Most of the money in circulation is from bank loans. Bank money, as it is sometimes called, is issued in US dollars, but lasts only until the loan is paid off. It follows that for the economy to prosper there must be ongoing business activity requiring loans. When that activity declines, for any reason, businesses lay off workers and the possibility of recession looms.

It is perhaps more interesting to find that bank loans can create money “out of thin air.” Where do they get it? New money has to come from the only entity that can create dollars, the US government. Yes, the government is involved at the very heart of our private enterprise system; it supplies the money.

Deposits Increase a Banks Required Reserves

The Fed, our central bank, charters certain banks that subscribe to rules about capital-to-loan-ratio requirements, and regulations that allow those banks to have accounts with the Fed. The balances in those accounts are called reserves, and they are oh so very important to the banking system. 

Reserves are money that banks must have in their vaults or on deposit with the Fed to meet withdrawal demands.

We know that a bank is not a piggy bank that holds our money in a box. When Anne deposits her money in a bank account, it creates a liability for the bank, because the bank must honor immediately any cash or check withdrawals demanded by Anne. Savings accounts are not “demand” accounts as there can be a time lapse for large transactions before withdrawal. As soon as the demand is made, the bank must make that amount of reserves available in it’s reserve account at the Fed so the check will clear. 

Throughout the banking system these reserves are clearing balances to assure that our checks don’t bounce. Thanks to the Fed’s reserve management system, a check presented to any bank will be honored by any other bank anywhere in the nation.

Loans Create Bank Deposits

A loan begins with a creditworthy customer, Anne, who signs the loan note and the bank deposits the loan amount in her account at the bank. Look at the way assets and liabilities balance. Anne has the bank deposit as an asset and the loan as an equal liability. The bank has Anne’s account as a liability and her loan note as an equal asset. 

As Anne pays off the loan her liability vanishes as does the banks asset. As Anne draws down her account she diminishes her asset, as well as the bank’s liability, and reserves diminish accordingly. The reserve requirements are passed to the banks where Anne’s checks were cashed. 

There is no lasting effect on the total amount of all reserves in the banking system. If everyone cashed all their checks in one day, there would be enough deposits to cover them to the penny.

If Anne made good use of her loan, she might have acquired real assets (land, a patent, donkey and gold pan, etc.) and increased her wealth.

Banks Borrow to Meet Required Reserves

It is often thought that banks loan only what they have on deposit. That’s not the case. The Fed will make reserves available “out of thin air,” at a price, after a loan is made. In lending, banks are not reserve constrained; they are constrained by bank capital (net worth). 

Interest bank pays to depositors is close to FFR.

Banks determine their reserve requirements at the end of each day by tallying up the direct deposits and loans, which increase required reserves, and the cash withdrawals and checks presented from other banks, which reduce reserves. If they are short of reserves they must borrow the funds from banks that have excess reserves.

Interbank trading of reserves occurs in the overnight funds market at loan rates determined by the Federal Funds Rate (FFR) that the Fed controls as a matter of policy. To carry out its Congressional mandate to maximize employment and restrain inflation, the Fed tries to regulate the economy by adjusting the FFR, which is the cost of money to banks. It is expected that by raising or lowering the FFR the Fed can discourage or encourage loan activity, respectively.

Reserves that are not required for a particular day or other accounting period, usually two weeks, are considered excess. Because reserves earn little or no interest, banks like to keep them at a minimum by loaning them to banks with deficient reserves.

If a bank can not borrow reserves from other banks, it can borrow from the Fed’s “discount window” at a slightly higher rate to meet its periodic reserve requirements.

Conclusion

Bank loans inject money into circulation until the loan is paid off. If loans are made faster than they are retired, business activity and, along with it, the money in circulation increases. Otherwise, money in circulation and business activity decreases.

The Fed sets the FFR as a matter of policy, not through external markets.

Contrary to the common perception that reserves are loanable funds, reserves are not loaned out of the banking system; they are loaned only to other banks!

If money entered the economy only through bank loans, there would always be reserves available to meet demand. That is, reserves would equal deposits. In the next blog, we look at how government spending and taxation affect this picture.

Related Reading

Building bank reserves will not expand credit

The role of bank deposits in Modern Monetary Theory

Thanks to Duane and Joanne, who helped make this topic more understandable.