money notes 2 13-13

Why Government Deficits are not a problem

John Bradford, Ph.D.

‘Taxes Drive Money’Fundamentals

• Money is fundamentally a unit of accounting; a unit of measuring credits and debts.

• This unit is determined by a government that issues currency denominated in this unit (e.g. US Dollars).

• Money is valuable because governments accept only their own currency as a means of payment for taxes (and fees and penalties, etc.)

• Money is accepted as a means of exchange because people need money in order to pay taxes.

How Money CirculatesHistorical Illustration

Rome issues (spends) coins to Roman soldiers occupying a village. Rome then imposes a tax on the villagers, and the tax can only be paid in Roman coins!

Now, the villagers will provision the Roman soldiers with food, clothing, shelter, etc. in exchange for these coins, so that they can use them to pay taxes to Rome.

ROME

OCCUPIED VILLAGE

Accounting Fundamentals

• In the aggregate, financial assets always equal financial liabilities.

• In other words, TOTAL DEBTS = TOTAL CREDITS;

TOTAL DEBITS = TOTAL CREDITS; or lastly, TOTAL BORROWING = TOTAL LENDING.

Accounting Fundamentals

• WHY? One person’s debt (liability) is another person’s credit (liability).

$100

IOU$100

“Bob”Banker

ASSETS LIABILITIES

$100 cash $100 DEBTASSETS LIABILITIESBob’s IOUworth $100

$100 cash(loaned to Bob)

Accounting Fundamentals

ASSETS = LIABILITIES• “Net worth” is a ‘residual’ category: NW = FA + RA - FL• TOTAL Net financial wealth = the sum of all financial assets less

the sum of all financial liabilities, which always nets to ZERO. Why? Because total financial assets = total financial liabilities.

• However, nonfinancial or REAL assets (i.e. material wealth) DO NOT SUM TO ZERO- i.e. ARE NOT OFFSET BY ANOTHER’S FINANCIAL LIABILITY.

ASSETS LIABILITIES AND NET WORTH

Financial Assets (FA)Real Assets (RA)

Financial Liabilities (FL)Net Worth (NW)

Accounting Fundamentals

WHY DOES THIS MATTER?• If total financial assets = total financial liabilities,

then the financial liability (DEBT) of government must EQUAL the financial assets (SAVINGS) of the non-governmental private sector!

• Summary: government debt = private savings!

ASSETS LIABILITIES AND NET WORTH

Financial Assets (FA)Real Assets (RA)

Financial Liabilities (FL)Net Worth (NW)

Deficit Spending by the Government => Net Saving in the Private Sector

Government Net Liability = Non-Government Net Assets

Accounting Fundamentals

• Here is what happens when $10 of interest is applied: Banker’s assets increase $10, and “Bob’s” liabilities increase $10. This is a net transfer of wealth of $10.

$100

IOU$110

“Bob”Banker

ASSETS LIABILITIES

$100 cash $110 DEBTASSETS LIABILITIESBob’s IOUworth $110

$100 cash(loaned to Bob)

Accounting Fundamentals• The application of interest makes the financial assets of

the banker and the financial liability of the borrower GROW EXPONENTIALLY.

• Assets still equal Liabilities in the aggregate, but the net financial wealth of the bank increases by the same amount as the net financial wealth of the borrower decreases.

“Bob”Banker

LIABILITIES

$110 DEBT

ASSETS

Bob’s IOUworth $110

Net transfer of $10

Accounting Fundamentals• Unlike governments and unlike banks, “Bob” can only

acquire the money to repay his liability from somewhere else. From where?

• In the aggregate, all new money comes either from the government (in the form of deficit spending) or from banks (in the form of private loans’).

“Bob”Banker

LIABILITIES

$110 DEBT

ASSETS

Bob’s IOUworth $110

Net transfer of $10

Explaining Public Deficits

• Normally, tax revenue will be less than total government spending: TAXES < SPENDING

• Why? Governments cannot collect more money than they have created!

$10

TAXES <= $10

Government Public

Is ‘Public’ Debt a Problem?

• A government cannot collect in taxes more money than it makes available: if all ‘debts’ were paid off, there would be no money left in circulation!

TAXES < SPENDING• Deficits are normal, and budget surpluses are

necessarily temporary.• Unlike households, currency-issuing

governments have no budget constraints.

Two Views on ‘Money and Taxes’

Conventional View • Taxes finance government spending. Whatever

revenue isn’t collected in taxes must be borrowed by issuing government IOU’s (i.e. bonds).

‘Taxes-Drive-Money’ View(Lerner 1943; Wray 1998)

• Governments do not ‘need’ the public’s money in order to finance their spending! Instead, the public ‘needs’ money issued by government in order to pay taxes.

Is ‘Public’ Debt a Problem?Two Views on ‘Austerity’

Conventional View • Persistent deficits should be avoided • Austerity is the inevitable result of

‘too much’ borrowing and spending, and its ‘remedy’!

• NO PAIN, NO GAIN‘Modern Money’ View• Persistent deficits are normal. • Austerity is unnecessary and self-

imposed.• ALL PAIN, NO GAIN! Austerity protests in Greece

Public Money vs. Private Credit

Public (State) Money Private (Bank) Credit

Currency created by state via “deficit” spending

Private credit created by private firms as loans,

Collected (or ‘destroyed’) through taxation.

Collected (or ‘destroyed’) through repayment of loans.

“Debtors” = tax payers; whoever has to pay taxes.

Debtors = borrowers; whoever is originally given the money

Locus of Debt is flexible Locus of Debt is fixed

Public Money vs. Private Credit

Public (State) Money Private (Bank) Credit

Value is relatively stable, based on governments ability to collect taxes

Value is volatile, based solely on the expected ability of borrowers to repay original loan, plus interest

Facilitates indirect, Generalized Exchange

Facilitates direct, Dyadic Exchange

Counteracts inequality Amplifies inequality

Linking Inequality and Debt

• New money (i.e. credit) is primarily loaned into existence by private banks.

• Because of the application of interest, total debt will always exceed the size of the existing money supply to repay it.

P+I(TOTAL DEBT)

MONEY (amount that can be used to

pay debts) <

Linking Inequality and Debt

1. The current system functions like a pyramid scheme: it is built on the expectation of infinite, exponential growth!

2. This is impossible, because aggregate financial wealth always nets to zero. (assets=liabilities).

3. Interest payments generally do not recycle back into the general population as earned income.

Linking Inequality and Debt

• COMPOUNDING INTEREST INEQUALITY• Compounding interest means that creditors

exponentially expand their claims on wealth.

Linking Inequality and Debt

• The debt pyramid is like a game of musical chairs: in the aggregate, the total liability of the borrowers can only be paid off (cancelled) with the creation of new money,

• New (net) money comes from only two possible sources: 1. Private banks, which will lend the money, thus

reinforcing the debt cycle, or 2. Government, which can deficit spend, i.e.

spend more than it collects in taxes, thus adding net reserves to the system.

Money Creation in the U.S.(standard view)

US Treasury

Federal Reserve

IOUs (Bonds)

Federal Reserve prints money, from nothing, and pays Treasury.

Money as Debt

Whatever bonds the other banks do not purchase, the Federal Reserve purchases.The Federal Reserve can exercise a power that the Treasury cannot: it can simply print the money from nothing! But it creates this money as public debt, i.e. the government’s liability.

Money Creation in the U.S.

• In the US, the Federal Reserve prints “Federal Reserve notes” which function as legal tender or fiat money.

• This money essentially represents debt to the Fed, (i.e. the government’s liability).

• US coins, however, are produced by the US Treasury, and do not represent debt to private banks.

The United States does not “borrow” Dollars from China

• The United States cannot “borrow” dollars from China because China does not produce dollars!

• Instead, China trades their goods in exchange for US dollars.

$USDollars

Chinese Goods

The United States does not “borrow” Dollars from China

• Next, China trades these dollars for interest-bearing IOU’s (bonds) called Treasuries.

• Treasuries are just promises to pay back more dollars in the future.

• This is basically like moving one’s cash from a checking account to a savings account, that earns interest.

IOU Dollars(Treasuries)

$US Dollars

The United States does not “borrow” Dollars from China

• The bottom line: THE US GOVERNMENT NEVER NEEDS TO ‘BORROW’ THE CURRENCY (MONEY) THAT IT CREATES IN THE FIRST PLACE! (whether from China, or anyone else)

• Any currency-issuing government can ‘afford’ anything sold in that currency.

IOU Dollars(Treasuries)

$US Dollars

Holders of US Treasury Securities 2010

Individuals12%

Mutual Funds7%

Banking Institu-tions3%

Insurance Companies

3%

Federal Reserve11%

State and Local Govts

6%

Foreign48%

Pension Funds9%

Other2%

Here is some actual data on who holds US government debt.

More than half of the public debt in the US is owned within the US.

Instead of borrowing the funds, the Treasury could have 1. raised the money through taxation, or 2. printed the money itself, debt-free.

China26%

Japan20%

United Kingdom6%

Oil Exporters 5%

Brazil4%

Carib Bnkng Ctrs 4%

Taiwan4%

Russia3%

Hong Kong3%

Switzerland2%

Other23%

Major Foreign Holders of Treasury Securities 2011

The countries that own the 47% of foreign-owned Treasuries