Government Debt –> What is it? How does it work?

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There is a common debate being displayed on the internet when discussing the national debt.  First, a person will chime in saying the debt is unsustainable when looking at the interest payments and the amount of taxes the government receives.  Then another person will chime in and say “the debt isn’t what you think it is.”  The first person just can’t fathom a debt that doesn’t matter as much as he or she perceived, and since they refuse to read up on the issue (it takes some time), while misunderstanding how the system works, he or she continues to disagree with what person B is saying.  Usually, people who view this “new” national debt are labeled as liberal, and the other party as conservative.

The best way to understand how the system works, is to view the economy as a flow of money.  The flow of money has three major segments.  Treasury to the Banks, the Banks to The Fed, and The Fed to the Treasury.  I would argue that this triangle is the core of our financial system, as the flow between these three bodies encapsulates the whole process of printing.  Let’s start with The Treasury.

The Treasury has two accounts.  Its “tax” account, and its “spending” account.  The Treasury has a target amount of money to work with each day.  Meaning, the goal is to reach that same amount day after day.  It isn’t precise.  The Treasury is able to print treasuries, or basically T bonds, or treasury bonds.  A bond is when a person gives a principle amount of money, and after the lifetime of the bond, the principle plus interest is paid back.  With a treasury, the bond is backed by the US government.  It is literally an asset that is safer than money itself.  If I am a billionaire and I have my assets as cash in banks, if an account is more than 250k it isn’t backed by the FDIC.  If the banks go under, then my cash goes with it.  But if I buy bonds that are backed by the US government, the US government will pay me back.  Therefore, this asset is in high demand, especially right now.  And treasuries, are the back bone of this entire system.

National Debt –>  Total outstanding treasuries.

Outstanding in this context, the financial context, means issued and sold.  So when the national debt clock increases over time, that means more and more treasuries have been bought.  Treasuries, like any other bond, has different lifetimes.  Month, three months, six months, year, ten years, even thirty years!  Over the course of the bond’s lifetime the interest on the bond is readjusted in accordance to the market’s conditions.  This is fundamentally important, because this means not all treasuries have to be repaid at once.  It is obvious, but becomes increasingly important as more is learned.

At the beginning of the day, The Treasury pays out what is due in expiring treasuries.  The remaining money that is in the “spending” account, is deficit spent.  Meaning, it is just spent in government programs.  (This is why fundamentally, regardless of ideology, the government is going to continue to grow in size.)  The Treasury then calculates what taxes they will receive from the bond holders later on in the year, and credits their spending account with tax money from their tax account.  Then, the remaining amount of money needed to put The Treasury’s spending account current, or in this case, the target amount of money that The Treasury works with each day – the required amount is printed in treasuries and they are ultimately sold.  This puts the spending account around the same amount of money it was at at the beginning of the day.  Currently, we are printing treasuries to pay for interest on treasuries.  Meaning the amount of money the Treasury prints is more than the amount of money The Treasury pays out.

When money is deficit spent, it is new money being deposited into the economy.  New money that gets spent on government programs, contracts, and employees.  They deposit money into their banks, and their banks get new deposits.  This increases the total liabilities that the banks have, which means their reserve accounts go up.  A bank, when it is issuing a loan, takes three main points into consideration.  What is the market for loans?  What is the customer’s credit?  What is the current reserve situation?  More reserves do not promote lending, however it allows for more lending.  That’s really important.

With more reserves being added to the system, eventually loans are made.  Loans are made through credit creation.  This basically means banks just fabricate the loan from nothing – they created credit out of thin air.  With all of these loans being made, and considering that loans are paid back over time, the net result is the expansion of the money supply.  This is crucial, because you need a growing money supply to meet the demand of money of the entire economy.  If there was a finite amount of money, the economy would screech to a halt because everyone would save their money because there would be no more to earn.  A growing money supply allows people to make more and more and more money.  Where this is relevant, is this allows people investing in treasuries, as well as new people to invest in treasuries, which allows treasuries to be bought consistently.

So a quick recap.  The Treasury pays out to bond holders that have expiring treasuries, and deficit spends.  This money ultimately increases bank reserves, which allows for more loans.  This expands the money supply, allows for more money to be invested into treasuries, who buys treasuries to put The Treasury’s account current.  Rinse and repeat.

As one could tell, it’s a feedback loop.  Deficit spending in essence takes the old bank loans and puts them back into the reserve system.  That’s important, because banks do not create reserves when they issue a loan.

There is one more step.  If one were to think about it, with the increasing amount of treasuries bought, the amount of treasuries to be paid out increases.  This decreases the amount that can be deficit spent.  Eventually the entire spending account will be used to pay out expiring treasuries.  Every year, The Fed transfers its “profits” to The Treasury, thus expanding the spending account.

How does The Fed make money?

The Fed makes money by providing services for banks, interest by providing loans to/for banks, and interest from the treasuries that it buys.  All of this interest is put in a server running a program that buys and sells currencies on the foreign exchange market.  The Fed then determines its expenses, and the remaining profit is then transferred to The Treasury.  This allows The Treasury to pay out existing debt, deficit spend, and sell debt at an expansionary rate.

There are some details that I left out, but I covered pretty much the entire printing process.  It’s really basic, it’s just people have to go out looking for it.  In my opinion, from the scholarly articles, journals, and books that I have read on this issue, our basic economic courses need an upgrade.  For example, my macroeconomics text book says banks create money from fractional reserve, where I read a study where economists were able to follow the books of a bank in Europe.  They created credit from nothing.

There are many implications and further understanding to take this.  But I want this post to be about how we print specifically.  Once that is understood, it can be seen that what we are doing is totally sustainable.  There are some people that think we can print as much as we want how fast as we want, and there will be no consequences.  I tend to think there are consequences on any action in this universe, so I do believe you can print too much.  But that is part of the reason of taxes.  It decreases the amount of you have to print to make The Treasury’s accounts current.  In essence, it slows the rate at which the national deficit increases.  If you have GDP increase as well, you can keep a certain target debt to GDP ratio.  Our is around 1, and Japan is over 2 and they are doing fine.  Yeah Japan has had some contractions/recessions/depressions however you want to define it.  But it is ignorant to think it is solely due to their debt levels, and not something else as complex as an economical system.

An indication on if you are printing too much is inflation.  However, it is usually the case with central banks, to keep inflation around 2 percent.  Not sure why.  If that starts to change significantly you can decrease demand by increasing taxes, or interest rates, or both.  If you would want to ease up on the taxes and interest rates, then it would be wise to deficit spend less.  Deficit ultimately helps put more money in the economy and thus increases demand.  If supply can’t keep up, prices increase.

I hope you all enjoyed this post!  Leave your comments/questions below.  Thanks!

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1 Comment

  1. September 18, 2016 at 1:04 pm

    […] Not only should one consider the entire budget of The United States, but consider as well the printing power that this country has.  People don’t like the idea of paying for someone else to live; they […]

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