Let’s step way outside our comfort zone here and take part in a discussion that, I think, we need to have. It is about money. If the article reproduced below is an accurate reflection of how debt and deficit work, then we need to talk about it instead of playing the mindless games we play at the moment in respect of taxes, spending, the supply of money and debt and deficit, in general. There are many similar articles available online under various headings, such as, High Powered Money, Monetary Base and others but this one is, I think, the easiest to understand.

The article is taken from the Democratic Underground website but its authorship is unclear. It is quite long but, as you will discover, necessarily so. If it is an accurate description of the story of money then we need our politicians to come clean and end some of the more absurd claims they make about debt and deficit.

The article starts here.

Taxes don’t fund government; public debt doesn’t need to be paid off

In this post, I foolishly wade into the sticky morass that is monetary policy. Bear with me.

A common way to look at how taxes, government spending, and public debt work is a very intuitive one:

The government takes in taxes. These taxes are used to pay for government spending. If the taxes are more than the spending, the government runs a surplus for the year. If the taxes are less than the spending, the government runs a deficit for the year, and must issue bonds (borrow money) to make up the difference.

This is intuitive but completely wrong, and gets backwards what is actually going on.

I want to start with the end of that paragraph in particular: “and must issue bonds (borrow money) to make up the difference”. Even a very conventional economist will eventually admit that this isn’t in fact true; the government (assuming it has its own central bank – so we’re not talking about the Eurozone right now) can also “print money” to make up the difference. It can simply say “well, through the magic of central banking we now have the money to make up the difference between receipts and outlays.”

So, borrowing is one way a government can “make up the difference”; not the only way. And looking at the question with that in mind, one is led to the fundamental fact that a government like the US’s actually can’t ever “need” dollars; it is capable of generating as many of them as it wants instantly. So looking at taxes as a way of getting dollars that the government needs for spending is clearly wrong.

But why, then, does the government tax or borrow at all? Why not just create the money it needs every year? Even a high school economics student can tell you, “inflation”: doing so will decrease the value of money to the point that it’s not worth doing. But this also leads to my first point:

Taxation isn’t a way to get the government revenue that it doesn’t (and can’t) need; it’s a way to control the money supply.

Since the government can’t need a dollar, and can create them at any time it wants, it’s possible to look at every dollar paid in taxes as disappearing from the economy, and every government dollar spent as being created when it is spent. Actually, it’s better to look at it that way: as we’re fond of saying, “a government is not a household”, and getting rid of a model that treats it like one is a good thing.

So why does the government borrow money? I’m glad you asked. Look at a bond issue from the perspective above, of money being created when the government spends it and destroyed when the government receives it. When the government borrows money, it takes (ie, destroys) a dollar now in exchange for a promise to spend (ie, create) a dollar and a bit more later. It’s a way of signalling the intended future size of the money supply, and of growing it at a predictable rate. Just like with banks, debt is where growth comes from. Furthermore, since we use the bond market to set interest rates (ie, how much the “a bit more” above actually means), it’s also a way of gauging the market’s reaction to the proposed future money supply.

Currently, for the US, that “a bit more” is actually negative in real terms – people are asking for a lower return on bonds than the already-low rate of inflation. To put it facilely, the world is paying the US government for the privilege of lending us money. What the market has achieved (whether it “wants” this is a different question, one I can’t answer) is that instead of promising a steady future growth of the money supply, the debt as it stands will decrease the (real) money supply as the government pays (creates) less in real terms for redemptions than it received (destroyed) for the original bonds. On a side note, this is probably a decent argument for stopping all taxing (which has the same effect on the money supply as negative-interest borrowing) until the interest rates come up enough that borrowing is again a net real money-creator rather than money-destroyer. Also as a side note, this is what’s “actually” going on with the QE attempts at the Fed: if the debt isn’t monetized now, it will end up shrinking the real money supply when it’s redeemed, which nobody wants (like I said, an easier version of the same thing would simply be to stop all taxation for a year or two and let the deficit get up to where the market “wants” it).

But then the debt would increase. Quelle horreur! I often hear “we can’t leave this debt for our children to pay off”, and I scratch my head a little each time. This leads me to my second point:

The national debt never needs to be “paid off”.

It never needs to be smaller than it is. In fact, “paying it off” would be a pretty horrible idea and would send the fixed-income market (and with it, most of our retirement funds) reeling. Again, governments aren’t households. For that matter, raising taxes and cutting spending to “pay off the debt” (one or both of those being everybody politician’s basic plan, seemingly) completely misses the point, I suppose because it buys into the “taxes pay for government” fallacy. US debt is dollar-denominated. The US government can create as many dollars as it wants. If the debt per se is actually a “problem”, particularly “the most pressing problem of our day” or whatever, then we can pay it off tomorrow if we want (we don’t want, which is why we haven’t) at the cost of inflation.

But what about interest payments? What about them? They’re kind of the point: the purpose of the bond was to destroy some money in the past and create a somewhat larger amount of money in the future. This is a feature, not a bug. Whenever I mention that real interest rates are negative someone always says, “yeah, but they won’t always be”. To which my response is, “great, then the debt will finally be able to go back to doing its job of predictably increasing the money supply”. We would like positive (if low) real interest because we would like the debt to continue to be a money supply growth tool.

The public perception problems here are tied up together. If you think (wrongly) that “taxes fund government” rather than (rightly) “taxes are a way the government controls the money supply”, then you also think “debt means that at some point in the future we will need to pay more or receive less to pay it off”. But, of course, being “in debt” of something you control the supply of is a ludicrous idea. It may well be useful at points in the future to destroy more money (raise taxes) or create less (cut spending) in order to change the balance of the money supply expected in the future, but (firstly) this is hardly the end of the world it’s presented as, and (secondly) we only “need” to do either if it’s more convenient for us in terms of the size and value of our money supply.

Governments are not households. There is no repo man who is going to come take Mount Rushmore. The national debt is a (pretty good) technique we have to manage current and future money supply, and it complements money destruction (taxes) and money creation (spending) pretty well.

Also by John Kelly:

Hockey’s Class Warfare

Leadership Speculation: Don’t you just love it?

What a Circus!

Dealing with Drugs: a new approach.

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