Understanding Government Debt

"Our nation's wealth is being drained drop by drop because our government continues to mount record deficits. The security of our country depends on the fiscal integrity of our government, and we're throwing it away."  Senator Warren Rudman.

Warnings like this are commonplace today. The assumption is that the Federal government has limited financial resources and at some point will be unable to service its growing debt, in short that it will become bankrupt. Responsible fiscal policy is viewed as requiring a balanced budget. Individuals and firms can indeed borrow their way into bankruptcy. There is no such danger for the government when it borrows in the same currency that it creates. In a fiat money system the government has just as much money at its disposal under a budget deficit as with a budget surplus.
     
When we adopted a monetary base of intrinsically worthless paper money in the mid-20th century, we created a new paradigm that is still widely misunderstood.  The imperatives are quite different from those of the earlier gold-based system.  The key to maintaining the purchasing power of money is to control the price of credit. That means controlling the cost to banks of acquiring the reserves they need to cover their depositors' transactions. The Fed has the primary responsibility, but the Treasury plays an indispensable role.

Government Money

We can think of "government money” as existing in two forms:  the monetary base issued by the Fed, and securities issued by the Treasury. Base money represents immediate purchasing power, while Treasury securities represent future purchasing power. Treasury securities necessarily pay interest to compensate owners for the delay in purchasing power.

The private sector runs mainly on bank money created by banks when they lend to the public. Banks must hold enough reserves of base money to cover their depositors' transactions. The amount they must hold varies with the net amount of borrowing, which in turn depends on the interest rate. Since the Fed controls the interest rate, it is ultimately up to the Fed to limit the demand for bank money to what the public can absorb without undue inflationary pressure.

Treasury Operations

The Treasury deposits its receipts from taxes and the sale of its securities into accounts at commercial banks, known as Treasury Tax and Loan (TT&L) accounts. It spends out of its account at the Fed, and replenishes that account with transfers from its TT&L accounts. To minimize variations in aggregate reserves of commercial banks, the Treasury targets a constant balance in its Fed account. Thus for all practical purposes, the Treasury spends out of its commercial bank accounts.

If Treasury outflows consistently exceeded inflows, its general fund would soon be depleted. Therefore the Treasury recaptures all of its spending on average. It does so with taxes and the net sale of securities when there is a shortfall in tax revenues. In effect the Treasury pays for its deficit spending by issuing securities rather than base money. That means deficit spending has no net effect on the immediate purchasing power of the private sector.

Tax or Borrow?

The choice between government taxing and borrowing, i.e. fiscal policy, is entirely at the discretion of Congress. That choice has economic consequences which can be either good or bad. Unfortunately fiscal policy is often governed by the belief that deficit spending is ipso facto bad. The real economic consequences are seldom considered in that decision. 

Deficits represent no financial risk to either the government or the public. All too often the focus has been on irrelevant accounting issues. Indeed attempts to balance the budget can easily be counterproductive, especially during recessions. Indeed when the economy is sluggish or in recession, deficit spending helps support aggregate demand needed for recovery.

Rolling Over Government Debt

Nothing about government debt requires that it be paid off. Of course individual securities must be redeemed as they mature, but the Treasury can roll over its maturing debt indefinitely. Rolling over means selling new securities to pay for the redemption of maturing securities. This involves no new tax revenues.

Treasury securities offer a risk-free, interest-earning alternative to base money spent into circulation by the government. If the private sector has more non-interest-earning base money in the aggregate than it wishes to hold, its only alternative is to buy Treasury securities. Since the Treasury can pay whatever interest rate the market demands, there will always be willing buyers of its securities.

Net financial wealth of the private sector

Treasury securities are valuable assets for the holders. They can readily be sold for money or pledged as collateral for loans. Together with the monetary base created by the Fed, they comprise the net financial wealth of the private sector. By contrast, bank lending cannot change the net financial wealth of the private sector because bank credit is matched by an equal amount of borrower debt.

The value of Treasury securities to the private sector as a whole is in the principal, not in the interest payments they shed. The interest payments are matched by tax revenues, and are therefore a wash in the aggregate. Some fear that as the national debt grows it will create an ever increasing inflation rate. That fear is not supported by the historical record. The debt/GDP ratio reached an all-time high at the end of World War II, yet the inflation rate during the next two decades averaged only 2%. In the following decade the debt/GDP ratio fell to a long-term low, while the inflation rate averaged about 8%. If there is an upper limit to the debt in terms of its effect on the inflation rate, it has yet to be experienced.

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