Forum Post: hudson on the real economy

People who understand how this country’s financial system works know the American dream doesn’t have to die. They know why the federal budget is not like a family’s budget or the budgets of companies and states. They know why the government can’t run out of money, default, or go bankrupt; and why Europe’s financial troubles won’t come here. They know the government can afford to do more to help educate young people, improve everyone’s health, provide income assistance as people age, foster a sound economy with good jobs, modernize the infrastructure, and protect the environment. And they also know that popular myths and deliberate misrepresentations of the system are hurting America.

Ask yourself two questions: 1) Does it make sense that millions of Americans who want to work can’t find jobs; that businesses can’t find enough customers; that state and local governments are laying off vital employees; that a record number of children are living in poverty; and that young people coming out of school can’t find the work they trained to do—all because a thing called “money” that societies create out of nothing is scarce? 2) Are you willing to learn how the financial system can help turn that around? If so, please set aside preconceived notions about government spending for a few minutes, and read on.

Like the economy, the financial system has three parts – the government sector, the private sector, and the international sector. Most significant actions by one sector affect one or both of the others. The system uses two types of money—bank credit that is created in the private sector credit and base money that is created by the government. Most of the money used in day-to-day transactions is bank credit. This paper explains important differences between the two types. Arguments about what the government can or can’t afford to do usually result from failure to understand how the three sectors and two types of money interact.

The mythical comparisons of the federal budget with the budgets of families, companies, and states are wrong. To begin with, they treat the government sector in isolation. Those who would balance the federal budget and eliminate its deficits don’t explain how these actions affect the other two sectors. In the real world, financial actions in the government sector always cause balancing reactions in at least one of the other two sectors and they affect the level of economic activity or GDP.

For example, during 2011 and 2012, the private sector sent just over one trillion dollars to other countries (the foreign sector) to import more than we exported. If those dollars had not been replaced by the government through the stimulus package and other programs, there would have been that many fewer dollars in the private sector and the economy would have slowed down more than it did.

The comparisons of the federal budget to other budgets are also wrong because they are based on the assumption that the government must get dollars by taxing or borrowing before it can spend them, in the same way that a family wage earner must bring home a paycheck before it is spent. As counterintuitive as it may seem, this assumption is exactly backwards. The government doesn’t get dollars from others, it creates them for others to get and use.

The government creates new base dollars by paying out more than it receives from taxes. Called “deficit spending”, creating new base dollars is widely but incorrectly viewed as a problem. In reality, it is a basic governmental function authorized by the Constitution.

The technical relationships between base money and bank credit are complex, but the principle is simple. One who borrows from a bank typically signs an IOU, has the amount of the loan added to his or her account at the bank, and gets checks to use for spending. The amount of the loan is bank credit, but it depends on base money in two ways. First, everyone knows that he or she can cash a check (if it doesn’t bounce) for currency which is base money. Without the explicit backing of base money created by the government, bank credit and checks would not be used so widely.

Second, bank credit depends on base money for what is called check clearing. This process is complex also, but the basic task is easy to understand. Every day, millions of people, companies, and others write checks that go to payees all around the world. The payees deposit their checks at their own banks or cash them. The clearing process connects the check writers’ banks and accounts with the banks and accounts of the payees. Most transfers are done electronically by the Federal Reserve System. The Fed uses accounts called reserves to run the clearing process, and most of the money in the reserves is base money that was created by the government. As its name suggests, base money is like a platform on which banks can build and operate their check credit structures.

There is an important difference between bank credit and base money. A person who borrows from a bank gets two things—the amount of the loan in the form of a bank account deposit which is an asset, and the IOU which the borrower’s liability that must be repaid. The two balance and equal zero. The IOU that the bank gets as an asset and what it pays out also equal zero. When the borrower repays the loan, all the assets and liabilities created by the transaction will cancel out and revert to zero. (If the borrower defaults, both the obligation to repay and the IOU are written off so the balance remains zero.) When a loan is no longer outstanding, the money is gone.

The government creates base money by spending more than it receives from taxes. It is an IOU of the government (either the Federal Reserve or the Treasury) but it is a net asset for households, firms, and banks in private sector. As discussed, banks use base money for clearing among themselves. Households and firms use it as currency, and they can exchange it for Treasury bills, notes, and bonds. These securities are also government debt and assets that the private sector can hold as safe savings that earn interest. Base money doesn’t vanish unless the government destroys it by taking in more from taxes than it spends or the private sector uses it to buy treasury securities.

The paragraph above is worth reading several times. To put the most important point differently, when the government runs a deficit, it creates the base money that banks need to operate and people need to save. Conversely, the government destroys base money by running a surplus.

When all the deficits and surpluses that were run since the founding of the Republic are added up, the total is known by the misleading term “national debt”. The national debt is just the amount of base money the government has created since 1790. While some of the base money is used to support bank credit, most of it is saved by people, companies, and financial institutions. Much of the base money winds up in such important places as savings accounts and retirement plans where no one wants it to vanish.

Recall that the government, private, and international sectors are interlinked parts of a single system. The previous paragraph highlights one of the links. The government sector can’t reduce the national debt by running a surplus that destroys base money without reducing private sector savings and eventually, slowing down the economy. This was demonstrated forcefully during the past fifteen years. When the government sector ran surpluses under President Clinton, it shrank the monetary base. Millions of people responded by borrowing more (negative saving) to maintain their standards of living. This private sector reaction kept the economy running, but only for a while. People increased their borrowing to record levels until the housing boom, which was financed with bank (and other private sector) credit, collapsed. Then, as debts were repaid or defaulted, private sector credit shrank, money started to vanish, people bought less, businesses slowed down or failed, and jobs were lost in a self-reinforcing spiral. Without the government’s creating base money quickly, (deficit spending) to fund the stimulus package and other programs, the Great Recession would have been significantly deeper.

The effects of large government surpluses are clear. In earlier years, they were run six times to reduce the national debt significantly in the mistaken belief that it was the right thing to do. Those six times were followed by the depressions of 1819, 1837, 1857, 1873, 1893, and 1929. And each time, the government had to create more base money by running deficits in order to recover, as it is doing now. Like it or not, the government and private sectors are like mirror twins who are joined at the hip.