US monetary system & deficits

 

The following will outline (with minor simplifications) the operational foundations of the US monetary system and address the economics of government deficits.

To explain the current monetary system of the US I will start with an example: The government sends a Social Security check to a senior who then deposits it in a commercial bank. The results of this are three-fold – the pensioner has a deposit asset, the bank has a deposit liability (it owes the money back to the pensioner on demand) and the bank receives a reserve asset. The reserve asset is a deposit at the Federal Reserve – this deposit is a liability of the Federal Reserve and asset of the bank. If the pensioner pays rent with the SS funds the commercial bank deposit is transferred to the landlord’s commercial bank account and if this account is at another bank then the deposit at the central bank is transferred from the first bank’s reserve account to the second bank’s reserve account. Now let’s say that the landlord withdraws $100 cash from her account and puts this cash in her purse and doesn’t spend it. This cash withdrawal does the following: it decreases the landlord’s deposit at the commercial bank, it decreases the commercial bank’s deposit liability and it decreases the commercial bank’s deposit at the Fed. The deposit at the Fed decreases because the Federal Reserve supplies the dollars that were withdrawn. Finally, if the government taxes the pensioner instead of sending them a check the processes above are reversed – their commercial bank deposit is reduced and the commercial bank’s reserves are reduced.

                The processes above capture the essence of the current monetary system.  A few key points to observe – 1) when the government spends it creates a net asset in the private sector (pensioner deposit increased) and when it taxes private assets are destroyed (deposits down) and 2) reserves at the Fed can only be reduced by either taxing them away or by changing them into a different government liability (cash in the above example). If the government spends more than it taxes then deposits are increased and reserve balances are increased (less any cash withdrawals). These facts lead to a key question – where does government debt come into play? As alluded to above reserves can be reduced by transforming them into different government liabilities such as treasury bills and government bonds. Why would the government decide to do this? Well, contrary to popular belief the reason why debt is issued is to maintain the Federal Funds rate (the rate that banks charge each other for reserves).

The yield on reserves is the government’s primary monetary tool. If the government wants a rate above zero it has two choices – to pay a return on reserve balances or drain reserves by issuing government debt (so that reserves become scarce and banks will bid up the price of reserves to the level the Fed wants). The US government until recently did not offer a return on reserves, which meant it needed to drain reserves by issuing debt - again, because otherwise there would be a system-wide reserve excess which would quickly drive the Fed Fund rate to zero as banks try to lend out their excess for a yield. Note that this operational reality also illustrates that the idea that government deficits “crowd out” private investment by increasing interest rates is not true – budget deficits actually put downward pressure on interest rates!! So now, with the government paying a return on reserves, there is actually no need to issue debt. This provides another conclusion – the US government does not need to be “funded” by debt and can NEVER go bankrupt. Spending is as simple as computer key strokes (wouldn’t we (individuals) love to be able to do this!!). The idea that the government needs to borrow so it can spend is simply not true. We do not borrow from China (they don’t make dollars bills!!), China instead decides to invest its revenue from export sales in government liabilities (instead of goods/services, higher yielding real assets or at home (which would drive their exchange rate up)). There is no limit to reserve balances (or if the government chose no limit to government debt). The only limitation on government debt is a self imposed one – to either limit government spending (for ideological reasons) or a function of a misunderstanding of the monetary system.

Misunderstandings arise from our gold standard history (pre-1971) where the money supply was linked to gold balances and thus reserves (part of the money supply) could not rise above the stock of gold – in this environment expanding reserves was not possible and debt issuance (not in the “money supply”) was required. Another common misunderstanding is that relating to “fractional reserve banking” – the idea that banks need to keep a fraction of their deposits as reserves and thus as a result can be thought of as levering-up their reserves (i.e. more reserves = more lending, the “money multiplier”). The problem with this myth is that banks are not reserve constrained but capital constrained (i.e. Basel rules, leverage rules, etc). Banks are never reserve constrained – the banks can always get reserves from the Fed via the discount window (borrowing from the fed), repos (giving assets to the Fed temporarily in return for reserves) or other banks. Causality actual works the other way – loans create deposits which create the need for reserves (which the Fed must supply or the payment/clearing system collapses). The interbank clearing system (which reserves facilitate) process trillions worth of transactions a day. If reserves were the real constraint on lending then Japan should have been on fire economically (due to credit growth) for the last 20 years (and the US should be now). The key to bank lending is profitability – they will lend if they can turn a profit (e.g. they need credit worthy borrowers). There are limited opportunities to do this now (in the US and Japan), plus because banks are close to their capital constraints (leverage limits). Lastly, the idea that the Federal Reserve controls the money supply is flat out wrong. When a bank makes a loan (an asset to the bank) it creates a deposit (a liability to the bank). This is an increase in the money supply (but not a net asset to the private sector as both assets & liabilities increase). Again, the only limit to this process (when regulators are not asleep) is banks capital ratio (i.e. bank’s need stockholder equity to cover potential losses on loans & other assets). Note that there are many myths about the money supply that could be another discussion in itself (e.g. inflation does not result from more money but from more spending (demand) relative to goods/services/asset supply – money that sits in your pocket is not driving up prices).

So having dispelled with any short-term concerns about deficits we can turn to long term questions – like what if deficit spending continued forever at high levels. To start it is important to recognize that the US has been in deficit during the majority of the last 200 years and that debt after WW2 was much higher than it is now or forecast in the medium-term future. Further, it should be remembered that the US does not have an expiration date (I hope not) such that there is not a day of reckoning when all debt needs to be paid back – so the claim that we are leaving debts to our kids is not entirely accurate as they can simply pass it on to their kids, and so on and so on. However, there is the claim that debt service costs will grow to huge amounts on current forecasts. The first retort to this claim could simply be that debt service costs are optional and that the US does not need to issue debt or pay interest on reserves. This line of argument gets complicated and in the end simply entails debt accumulation in a different form, so I won’t pursue it further except for the following. QE1 and QE2 are doing exactly this! The Federal Reserve is buying government debt and giving reserves in return. This is the same result as if the budget deficit was “funded” by reserves in the first place! The second main argument against forecasts of huge debt service costs is that they are simply wrong. The CBO is making very bad assumptions, possibly because they are using neoclassical economic models, or because they are looking at deficits in isolation of the broader economy. The forecasts are in essence suggesting that government deficits will continue, at an increasing rate, to add to economic activity (or savings). However, if this were the case, and assuming deleveraging (saving) desires moderate, this would imply huge economic growth, or possibly, high inflation. What the CBO forecasts really reveal are potential real resource problems – demand for goods and services are forecasted to expand beyond what the economy will be able to produce. It is widely recognized that with the number of retirees per worker increasing we will have challenges in maintaining output at the level required to maintain everyone’s standard of living. There are two ways to overcome this challenge: 1) expand our ability to produce goods & services from our real resources (which also reduce deficits due to the automatic stabilizers – income up = taxes up) or 2) force other countries to make things for us. The 1^st solution will be one of the main drivers for my economic policy recommendations (coming soon - so I won’t discuss it now, and as you can guess it won’t involve firing thousands of teachers and letting infrastructure fall apart). The 2^nd solution is a non-starter (for many reasons). If we don’t address this challenge then we are essentially faced with a distributional problem. One obvious way to lower standards of living is to increase taxes (you should think of taxes as an aggregate demand regulator – taxes up = AD down, taxes down = AD up) which would therefore distribute resources from the taxed in favor of the non-taxed. On the other hand you could do the opposite and cut government spending to spare the taxed.  These are important issues for the public to discuss – it’s too bad that the current debate is focused on a non-issue (funding problems), instead of the real problem (real output issues).

Government deficits are a demand regulator that allow people (non-government sector, including foreigners) to save while maintaining “full-ish” employment. During the great depression they didn’t realize this and had limited “automatic stabilizers” (e.g. government safety net, taxes based on income level, etc.) to make deficits increase without congressional approval and thus allowed economic devastation until the “new deal” and WWII. If the deficit didn’t greatly increase in the last few years we would have had a 2^nd great depression. If the government runs a deficit when the economy is at full capacity inflation will result (the idea that deficits never matter is NOT!!! a Post-Keynesian proposition). When the baby boomers retire and spend their accumulated savings (net dis-saving) the economy will expand and the only three ways inflation can be avoided is to expand output via productivity increases, lower demand via decreases in the deficit (more taxes or less government spending) or increase imports (which all countries can’t do at the same time).

Summary of Conclusions:

-          US government spending is keystrokes on a computer.  There is thus no limit to government spending. (The US Government is not like an individual!!)

-          Government bonds are issued to maintain the Feds Funds rate, not to fund spending

-          Government deficits put downward pressure on interest rates

-          Banks lend based on profit possibilities (credit worthy borrowers) and are capital constrained, not reserve constrained. The “money multiplier” is a myth.

-          Government deficits/surpluses are best thought of as aggregate demand regulators/adjustors

-          Aggregate demand needs an “adjustor” because there are leakages in the economic spending/income cycle (e.g. savings, imports) that cause deviations from our economic potential (resulting in either inflation or unemployment)

-          Long-term debt forecasts reflect faulty economic forecasting and real resource constraints

Special Note:

The European Monetary union is a disaster and will fall apart or change drastically (more than just Greece). Anyone who says the US is in the same boat is absolutely wrong – we use a different monetary system. Post-Keynesian folks have predicted the current European mess for more than a decade (as well as predicting our financial crisis).  Be prepared for more rough economic times as we will be affected by the European mess.