The Folly of A Balanced Budget Amendment
Full swimming pool
The hydrology of MMT
The young lady in the photograph above is there to capture your attention. But what I want you to focus on is the swimming pool behind her. We are going to use the swimming pool as the basis for seeing an analogy between Modern Monetary Theory (MMT) and hydrology.
Monetary theory is the theory of money and its role in an economy. Hydrology is the study of flows of water. The basis for the connection between modern monetary theory and hydrology is that monetary theory recognizes flows of money in an economy (Wray 2012) as important objects for theoretical analysis. Water and money are respectively fungible, that is, freely exchangeable for like amounts of the same kind of stuff.
Water flows are continuous movements of quantities of water going from one place to another over a period of time. Stocks, on the other hand are quantities of water kept in some place, like a reservoir, or tank, for some time.
Flows of money in circulation go from one or more persons to others, in a region or nation, as, for example, when one person buys something from another who gives back something in return. Money can flow around from person to person in a country, as buyers become sellers. But money leaving circulation is no longer part of circulation. So buying imports, buying securities (savings) with money already in existence, taking out time deposit accounts, paying taxes, are outflows.
Money can flow into circulation from foreigners into the country to sellers of goods, known as exports. It can leave circulation in our country when we buy goods made by foreigners, as at WalMart or Target stores. These are known as imports.
Money can flow from savings accounts or bank loans into checking accounts of businesses to buy raw materials, machinery, factory and office buildings. That money begins and remains in circulation.
It can be created and flow from banks when a bank makes a loan and the borrower takes the money to buy a new car. The car dealer then pays his salesmen and mechanics with money from sales. The workers become consumers, buying goods for their home and pleasure.
So creation of loans and transferring them to borrowers from the bank are inflows.
Flows of money from one person to the next and so on are what I call circulation. Circulation generally means the action of going around in circles, from place to place. Money stocks are bank vault holdings of money, savings accounts, time-deposit accounts. They sit for some time in one place. They are not in circulation.
That leads next to the concept of inflows and outflows of money into and from a sector, which I call "circulation". Circulation consists mostly of readily available, liquid money used for exchanges of goods and services between parties in the economy that moves around from party to party in the economy until it leaves circulation as imports, taxes, savings and/or payments of loans. It contrasts with inflows which are additions to money in circulation and outflows of money that leave circulation.
Circulation is not a static stock but a continuous mixing and flow of money from not just individual but sometimes many sources and parties to others in the exchange of goods and services for money.
Still circulation is like a stock because it represents a quantity of money enduring in market activity of a country for a period of time.
Because monetary flows are flows, it is possible to use water analogies. And hydrology is the study of water flows. Hydrology is a quantifiable science, using equations involving relations between flowing quantities of water.
We will draw upon one of these equations to gain an understanding of what we must do with money in circulation in terms of inflows and outflows of money from circulation. Anyone with junior high school algebra should be able to follow this.
Almost everyone focuses on balancing the budget. A balanced budget spends only money that is available from taxes. That's called fiscal policy. But at the federal level that is the wrong balance to focus on.
Modern Monetary Theory (MMT) is the description and theory of fiat money and its management in an economy. Fiat money is not backed by any commodity but rather by the full faith and credit of a government sovereign over its money.
According to MMT, what the federal government, including Congress, should focus on is managing the inflows and outflows into and out of circulation so that the amount of money in circulation can rise to a level, just enough to keep the economy at full production and full employment at stable prices and wages, and be kept at that level until population growth and shortages or surpluses of raw materials require a change. At this level the balance is to have inflows equal outflows.
Up to this level Inflows should exceed outflows. Beyond this level, outflows should exceed inflows until the desired level to sustain full production and employment is attained. Think of a swimming pool and what is needed in terms of inflows and outflows to maintain it at an optimum level for swimming.
I have to credit Arliss Bunny (2013) for stating this idea, which puts together a whole lot of MMT theory in a single sentence. She and I in our separate ways are trying to come up with simple, clear, sometimes funny ways to get across the powerful ideas of MMT. So this is why I begin by saying, "Think of a swimming pool." In order to swim, it should be full.
So, suppose water is always flowing out of a pool through various drains, some of which can be open or closed and adjusted, while others are not. Consider, for example, the picture of the swimming pool above (ignore the young lady). In the far right side of the pool, water seems to be flowing out and over to a water fall we can't see. And suppose further, there are various sources of water entering the pool. These also can be adjusted.
Now, the first thing to realize is that if you want to keep the pool full for swimming, you need to keep filling the pool through the inflows, while closing some of the outflows. Further, once full, you need to balance the amount coming into the pool against the amount going out through the various drains. And depending on how much water is entering through one inflow source, you will need to adjust other inflows to make the total inflow equal the total outflow.
If you have ever taken a bath, think of the inflow of water from the tap and the outflow of the water through the drain.
We also have to consider the level of water in the pool. The level is a function of inflows and outflows. If the pool is empty and we want swimming, we need to fill up the pool. We do that by having more water flow into the pool than out. In time the the water in the pool will rise to the full mark ready for swimming. Too little water, and there is no swimming. Too much inflow and water may be overflowing the boundaries of the pool. So, how much water is in the pool for swimming will be a concern. We will argue that money flows are like water flows.
In hydrology, the study of water flows, there is a fundamental equation:
IF - OF = ∆S
where IF is how much water is flowing into a pool or tub; OF is how much water is flowing out through the drains. That's outflow. ∆S stands for the change in quantity of water S in Storage in the pool. (The symbol ∆ means “change of”; it is not a variable or a number.) So, if IF (inflow) is greater than OF (outflow), ∆S is positive and storage S increases by S + ∆S. If OF (outflow) is greater than IF (inflow), then ∆S is negative, and quantity S in Storage is reduced by the amount of ∆S.
A similar mathematical equation occurs in physics as the first law of thermodynamics:
Q - W = ΔU
where U is the internal energy within a system and ΔU the "change in internal system energy U".
Q is the energy flowing into this system in the form of heat and W is the outflow of energy from the system as work done by the system.
OK, that‘s the analogy to help you think about this as a whole. Consider that money is represented by the water. In this case, it is dollars. The pool is the arena of circulation and you want the amount of dollars in circulation to be just enough to allow businesses to produce goods and services at full employment bought at stable prices negotiated between parties.
Now, let‘s consider the sources of money flowing into a country, where it then circulates, and the several kinds of outflow are drains.
For inflows, there is dollars from exports E (money coming in from goods produced in the US and sold to foreigners, who pay in dollars); there are dollars from government spending G (some by deficit spending); there are dollars circulating from Investments in business growth and maintenance. Keen (2012) claims that the housing bubble was not focused on because it involved private debt, produced by banks and the shadow banking industry, which the received view, neo-classical economics ignores because they believe all money is created by the central bank. Although I will not focus specifically on that, I‘m going to add L (bank loans to private borrowers, because banks create new money when they make loans and borrowers issue it into circulation). And "bubbles" are forms of inflation.
Contrary to myths held over from when gold backed dollars, banks do not take money from your accounts to lend money to others. When on gold, the bank had only the gold-backed money of its depositors to lend. So, it had to lend those. Our money is fiat money, money by decree. It is backed by nothing but the full faith and credit of the United States. The government decrees that the dollar is money and requires payment of taxes in it. Banks create money out of thin air when they loan; but it is debt to whomever it is given). Bank-created dollars are not the same as government created dollars, although they use the same unit of account in dollars. The creator of government dollars is the Federal Reserve Bank (the Fed), the central bank of the United States, which is a partnership between the federal government and private banks.
So, if we add together all these sources of inflows into circulation, we get
IF = (E + G + I + L)
Total inflow IF equals the sum of exports E, plus government spending G, plus investment money I, plus bank loan money L.
As for outflows there are dollars taken out of circulation in our buying imports M (like appliances from China and cars from Japan and oil from Saudi Arabia). There are dollars taken out of circulation in taxes T by the government. And there is dollars going out of circulation into various forms of savings, S, aggregate money not spent but saved. This is aggregate savings––sum total of how much everyone has saved in the banking system. P is the aggregate or sum total of repayment of debts to banks on their loans plus interest. Repayment of debts takes money out of circulation. It vanishes into thin air.
A lot of money in circulation is people buying goods and services between one another in the economy. Each seller may save some of his/her money from sales of goods and services while using it to buy goods from others. This money is circulating around in the banking system of this country. But some just sits in depository accounts and isn’t spent for awhile, if ever. That is savings. Ultimately over time aggregate savings, S = E + G + I + L, as each seller keeps (saves) a portion of the inflow of money he/she receives before using it to buy things.
If ultimately aggregate savings are equal to the sum of preceding inflows, it follows that there must be continuous sources of inflow to keep money in circulation supporting the exchange of goods and services between parties in the economy of a region.
When the Treasury sells securities but doesn't use that money for deficit spending, the money sits in time deposit accounts at the Federal Reserve like time deposits at banks backed by CDs. So, one thing we need to know is that money has to keep flowing into the system otherwise the money in circulation will drop and cause deflation (recessions and depressions with falling prices).
It will do this because not enough money will be available to buy all the goods produced. Producers will have to lower their prices to get all their goods sold. They may cut back production, lay off workers because they perceive demand for their goods is reduced while they are receiving less income for their products and cannot continue to pay all their workers at the wages they previously had.
When workers are laid off, they lose income and cut back their buying, relying on their savings until they run out. This further reduces demand for goods and a downward spiral in the economy develops.
OF = (M + T + S + P)
The total outflow OF of money is the sum of import money M leaving circulation, plus tax money T leaving circulation to the government which doesn't have to spend it, plus total of money S leaving to saving S plus money P leaving circulation to repay loans.
Now, let C denote how much money is in circulation at any given time. Let C‘ denote the quantity of money in circulation when there is full production of sellable goods and full employment at stable prices and wages for a given population and availability of resources.
Full production means all means of making goods is being used to make them. Full employment means everyone who wants a job has one. Being at full production with full employment, you cannot increase the goods and services by increasing money in circulation.
We assume that money is the medium by which exchanges of goods and services are made in the economy.
Money is tokens or quantitative representations of perceived value in units of account in exchanges of goods and services between parties in the economy.
Money has no intrinsic value and the values attached to it are established in prices negotiated between the parties in these exchanges.
A unit of money also has no unique value, and the different parties can perceive the value of the same money differently in a given exchange. But money is essential to making the exchanges of goods and services so the parties can explicitly see to what extent they are getting from their points of view equivalent value in their exchanges.
Someone has to create the money and inject it into circulation. Otherwise, without money, parties cannot efficiently conduct their exchanges of different goods and services. The federal government and our banks create our fiat money.
New money must be created and injected into the economy when money has left circulation in our country and has no ready impetus to move it back into our circulation. The Federal government is in the best position to do this via deficit spending.
If there is not enough money in circulation to clear the market of goods produced at stated prices and wages, vendors may have to reduce their prices and cut production, with corresponding layoffs of workers, who thus do not receive incomes. This can lead to a downward spiral of the economy as demand for goods drops as more and more workers are unable to buy them since they have been laid off and do not have incomes sufficient to buy them. This in moderate cases is a recession and in more extreme forms a depression.
On the other hand, if more money is circulating in the economy than is needed to clear the market of goods and services at stable prices and wages, then those with excess money can bid up prices. If the economy is at full production and employment, then no amount of additional money will be able to increase production and prices will generally rise across the economy while wages will just generally increase as competition for employees takes place between employers. This will be the case of inflation.
So the level of money in circulation at full production and employment at stable prices and wages takes on special significance.
Inflows IF greater than outflows OF flowing into circulation after C has reached C‘ (level at full production and employment, at stable prices and wages) is just excess money. (The pool is overflowing). At stable prices money is just sufficient to clear the market, and at full employment there are no more idle workers to be hired, and at full production, there is no additional immediate productive capacity to add.
So, the excess money at this point causes those possessing it to bid up the prices for goods and services while employers compete for workers by raising wages, causing inflation.
So, we do not want to cause inflation because that implies a devaluing of our money. More money is needed to buy the same goods and/or services. More money does not get more goods produced because we are at full productive capacity. We cannot add more capacity. (We‘ ll assume that the capacity is limited by the raw materials and workers available for production).
So, IF - OF = ∆C, or inflows of money minus outflows of money equals the change of quantity of money in circulation. Expanding IF and OF, we get,
(E + G + I + L) - (M + T + S + P) = ∆C.
This analogy works for our system because we have fiat money (which is not backed by anything but the full faith and credit of the government) and money like water is fungible (freely exchangeable for other of same kind of same amount). Fiat money is just tokens of debt obligations in units of account between parties in exchanges of goods and services in the economy.
Relative value of different amounts of money compared to goods and services for sale is negotiated between the parties in these exchanges. And our federal government is sovereign over the money supply, meaning our government can continually create new money as needed to maintain full production and employment.
Buying Securities with the Fed, Treasury, and Banks for Deficit Spending
I have modified parts of the following discussion on how deficit spending is financed because of new information I have received leading me to new understanding. The following material is "wonkish", meaning complex detail that may put you to sleep. So, bear with me. It is not generally known but essential to a full understanding of deficit spending and the national debt.
Treasury as government creates money in cooperation with three other entities: The Federal Reserve Bank (our nation's central bank, having considerable independence within the government, formed by a joint partnership between certain large U.S. private banks and the Federal government who have invested according to law in shares in the formation of Federal Reserve Banks for each of 12 regions in the United States; primary dealers and brokers in US Treasury securities and bonds at the Public Auction conducted by the New York Federal Reserve Bank; correspondent banks which have reserve balance accounts at the Fed, and the private banks when Treasury sells them securities it creates.
Securities are like IOU's but have a 'maturity date' when the borrower has to repay the lender on demand the value of money indicated on the IOU. They are sold at discount, and the difference between the discount price and the face value of the security is the interest. At maturity the securities are as good as money and may be exchanged for an equivalent amount of dollars.
Borrowing from banks replaced the procedure used between the Civil War and 1917, in which the Treasury simply issued US Treasury Notes, (greenback dollar bills) created 'out of thin air'.
The banks were out of the loop and missed all the interest. So, they lobbied hard and when the First World War finally drew in the United States as a participant, the banks took advantage of a fear that Congress might overspend by having a Treasury with unlimited power to create new money. So, the banks lobbied Congress for a law requiring the Treasury to borrow money instead of creating it. And in 1917 they succeeded in getting such a law passed.
But the new law effectively preserved the prior feature that the Treasury would not have to pay back the principal spent, while requiring it to pay only interest.
Banks today create new money out of thin air in a fiat money system whenever they make loans. They don‘t take money from depositor‘s accounts and lend that to others. However, bank-created money is not usable directly to buy securities of the Federal government issued by the Treasury. U.S. securities must be bought with reserve dollars created by the Federal Reserve Bank and accounted for on its bank ledger. That is essential, along with requiring taxes be in the form of dollars, to make citizens want to acquire this money.
So, when the Treasury issues securities and sells them at the Public Auction to acquire money for deficit spending, the banks need a way to either exchange their bank created dollars for Federal Reserve dollars or use some of their reserve dollars in their reserve accounts, or borrow reserve dollars from other banks. The correspondent banks can serve as brokers at which to exchange any bank created dollars for reserve dollars, or lend reserve dollars to the banks for the purchase. If the correspondent banks need more reserve dollars they can borrow them from other banks or even directly from the Federal Reserve. Federal Reserve (Fed) will create the money for buying the securities. First, you must know that by law the Federal Reserve cannot buy securities directly from the Treasury. So, the Fed, if it buys securities, has to buy them from some intermediary who gets them beforehand from the Treasury.
However the deficit-spending money, received by the Treasury and spent, is new money and a new addition to the money supply in circulation. If at this point the Fed takes the securities it has bought from the dealers and holds them to maturity, it will then be in a position to swap them for new securities with new future maturity dates with the Treasury. At this point the deficit-spending securities returned to the Treasury are extinguished (taken out of existence) by the Treasury. This cancels any debt obligation of government to the banks for the securities used for deficit sending. The Fed gets new securities to sell in the future if inflation arises. Selling these to nonfederal investors and to private banks, it will drain the money supply and bank reserves into time deposit accounts (the securities reserve account at the Fed), out of circulation, lowering the value of C and fighting the inflation.
So, if banks wish to lend to the Treasury by buying Treasury securities to earn interest, then how can they acquire government money to buy them?
With prior agreement with the primary dealers who seek to create the market for the securities by canvasing the banks, the banks will signal their wish to buy the securities. The auction will note the bids for them, and determine which banks win the auction. If they are informed that they have the winning bid for securities, the banks will then go to their correspondent banks and either borrow the government reserve dollars at a discount plus a penalty interest for the purchase (which often will be huge amounts of money), or exchange their bank created dollars for reserve balance dollars. which will be put into the banks' reserve accounts at the Fed. The securities to be purchased will serve as collateral in case the banks default and these kept in reserve securities accounts at the Fed.
Then at the Public Auction the banks will draw upon this reserve money to buy the securities from the primary dealers acting as mediating agents for the deal). The Treasury will get its money (from the overdraft lending), and the banks the securities (from the purchase of the securities).
Banks have an alternative way to directly borrowing reserve balance dollars from the Fed: Other banks will have these reserve balance dollars and may lend them to banks wishing to buy the securities. Then the securities bought are not collateral for the loan. But at some point the Fed will just directly buy them, giving the banks owning the securities the reserve balance dollars it needs to pay off the loans to other banks.
Still, since the Fed has no real immediate need to buy the securities from the banks, it may just allow the Treasury and banks to roll over their securities for awhile as they mature, allowing the banks also to get interest payments.
Since the Treasury manages the debt on its securities in these cases for deficit spending, and lacking the funds to redeem the securities sold, it may propose to the banks that the deficit-spending securities they have be rolled over perpetually, with swaps of new securities for mature securities from the banks, along with interest at each roll-over. At least the banks will get interest, even if they don't ever get the principal, but then the principal in its loan was created out of thin air in the first place. So, the banks agree to do this with the Treasury.
This rolling over can go on for some time. But eventually the Fed may want to acquire the securities.
If it needs to, in Quantitative Easing the Fed can go in and demand the banks' surrender of the deficit securities to the Fed. When the banks surrender these securities to the Fed in return for Fed reserve dollars created out of thin air, this cancels the government's debt to the banks on the securities. But this also extinguishes the dollars created by the Fed out of thin air, since a loan is effectively being paid back. Hence this money from the Fed never goes into circulation. What has gone into circulation is the dollars created by the banks and lent to the Treasury, which spends it into circulation. But the banks' dollars have been at some point exchanged for Federal reserve dollars, thus acquiring their legitimacy for payment of taxes.
But if the Fed wants to be nicer about it, it could just have the banks put the securities up at the Public Auction, where it could buy them back from the banks. These again cancel the government's debt to the banks while transferring it to the Fed.
Why does the Fed acquire these securities at all? It does so to fight inflation when it arises.
The Fed will keep the securities until they mature and then until inflation arises. Then it will take the mature securities to the Treasury and swap them for new securities. The Treasury will extinguish the mature securities returned to it, meaning the government's deficit loan to the Fed is now closed out. And the Fed then will sell the new securities to banks and investors to drain bank reserves and settlement balance dollars from circulation, which will counter inflation.
So, for deficit spending the Treasury will never pay back the banks the money they lent the Treasury when they bought the securities. Loans never to be repaid are not really debts.
The banks gain something from this because their buying the securities created an endless stream of debt free interest money coming back to the banks from the Federal government.
Other but inferior solutions would involve the banks not borrowing from the Fed, but collecting 'old' reserve dollars from circulation and saving that until the time came to use them to lend money directly to the Treasury for deficit spending.
If the banks buy securities directly through the dealers from the Treasury using 'old' reserve dollars they have collected or earned from circulation, they do not provide 'new' dollars; they simply recycle old dollars into deficit spending, which do not yield a net gain in the money supply. Since the principal will be spent on deficit spending, the banks lose on all the effort taken to acquire the reserve dollars for purchase of these securities. So, this method provides no new reserve dollars spent into circulation by the Treasury, nor do the banks get back the principal. All they get is the interest, which may be small. And the banks lose the principal when it is spent by the Treasury for deficit spending. So, doing this with 'old settlement dollars' is not so good a deal for the banks.
Banks will gain more and lose less if they don't buy securities for deficit spending but buy for investment. The occasion for this is excess reserves. If they simply buy securities directly from the Treasury with reserve dollars they have collected, this will 'store' the securities in spread-sheets in time deposit accounts at the Fed. This money will not be used for funding government operations. So, in this case the banks are investors rather then lenders for government operations. Their money continues in existence and will be returned to them plus interest upon demand when the securities mature.
Treasury sells the securities directly to banks. The banks will have either received loans of reserve dollars from other banks to buy the securities or use reserve dollars they have already accumulated. The banks lose the principal when their money is used by Treasury for the deficit spending. This means that the deficit spending money gained from the banks is debt free and new money. The banks, however, will be inclined to accept perpetual roll-overs of the debt with securities swaps from the Treasury. At some point the Fed may buy the banks' Treasury securities, which will enable the banks to pay off their loans for the purchase to the Fed or other banks, respectively. Or the banks may simply surrender the securities to the Fed, as described previously, to extinguish the debt.
Nevertheless the principal on the money 'loaned' by the banks to the Treasury still exists in the banking system, but now has become debt-free as the Fed buys the corresponding securities and then swaps them for new securities from the Treasury.
There are numerous ways in which securities for funding deficit spending may be sold. Banks don't always have to be used, since in some cases Primary Dealers may be used instead. Or Primary Dealers and Banks and the Fed may be buyers. We have only described the two simplest cases.
By now, you should realize why so few Americans understand or even know about government finance. It is complex, secretive, and difficult to explain. Nothing in ordinary Americans' experience should prepare them for the operations between the Fed, the Treasury, Primary Dealers, and Banks.
<b>The bottom line:</b> Taxpayers never have anything to do with managing the deficit debt; that is handled by the Treasury, the Fed, the Primary Dealers, and the banks.
The Fed acts more as a custodian and seller of the securities it purchases than as a complete owner of the securities. It cannot use any value for a security it has for its own well being other than 6% of the interest on the security as a transaction fee for purchasing the security. All other value has to be returned to the Treasury.
Fungibility of money and breakdown of the inflows and outflows.
Money is fungible, meaning it is freely exchangeable for other money of the same amount. We can consider now how we can have different amounts of money in different categories in an inflow or an outflow, but as long as they add up to the same total amount, they have the same effect on total inflow or total outflow, respectively, on circulation level C.
We need a way to indicate values at different times. We will use parentheses around expressions that indicate order in time. For example C(i) indicates a current value for C. C(i-1) indicates a preceding value for C
C(i) = C(i-1) + ΔC(i) = C(i-1) + IF(i) - OF(i) = C(i -1) + (E+G+I+L)(i) - (M+T+S+P)(i)
This has similarities to one expression for the Gross Domestic Product of a country expressed in monetary terms:
GDP = C + (E- M) + (G-T) + (I-S)
GDP in a given year equals Consumption + Export/Import balance + Fiscal balance + Investment/Savings balance.
But our formula allows one to think of total money in circulation serving current exchanges of goods and services as being a function of prior money in circulation to which has been added current inflows balanced against current outflows. One need not think of making government spending equal tax revenues, exports equal imports, savings equal investment. Any combination or mix of these values is possible to determine current money in circulation. Furthermore our formula explicitly includes bank lending and loan repayment as contributing to current money in circulation.
Suppose C currently is zero. Then we want to steadily increase C by making sure IF is greater than OF as money flows in and accumulates in circulation. But when we reach C’, full employment and production at stable prices and wages, we will stop filling the pool and just maintain the level of C at C‘.
What we want to do is to fill the “pool“ of circulation by keeping ΔC positive until C reaches C‘. At that point we make IF equal OF, that is,
IF - OF = ΔC = 0. There is no change in C.
One of the reactions of Austrian austerian economists to MMT is that governments will naturally abuse the power to create fiat money and cause hyperinflation. This was because it was not clear where the point was beyond which further money creation would be inflationary. That is a logical possibility. But it is not likely once everyone understands the signs of full production and full employment in inflation as indicators of when one has reached or exceeded the optimal amount of money in circulation, C'. Beyond that point you want to make ΔC negative until full employment returns, at which you try to make C remain equal to C' and ΔC = 0 again.
Consider another analogy here: guns are dangerous instruments, and it is logically possible for people to kill their family members, friends, strangers, themselves, with guns. But those who love guns will tell you that this is not likely to happen with those who know how to use guns responsibly and effectively. Of course, there will be those who are mentally deranged, or criminals, who will use guns to kill others, but we can control that to a minimum.
The same sort of thing is true with fiat money. Once we know how to identify when we have filled circulation to its full capacity C' for production and employment, we should continue thereafter to adjust IF and OF so that IF - OF = 0.
This is not necessarily a stable position. Population may grow, increasing unemployment. More money is needed to serve the larger population. If due to unforeseen influences the level of money in circulation changes, we should attempt to counter that with changes in IF and OF to bring the economy back into balance at a new C'.
Some individuals in circulation may want to save more than they have before. Or foreign buyers may buy more or less of our goods than before. Or foreign importers may produce less for us to buy, or lower or raise their prices. Those changes due to some categories of flow within either total inflow IF or total outflow OF will have to be adjusted to bring the economy back into balance at C'.
Congress has an important role to play in maintaining the balance of inflows and outflows. It can either cut spending when exports and bank lending increase, increasing inflow IF, or it can do deficit spending to compensate for drops in C from diminished sources of inflow such as reduced export sales E, or reductions in investment I, or lowered bank lending L or increases in outflows in S and M.
During inflations it can raise taxes T while cutting spending G to reduce growth in level of excess dollars in circulation by draining with taxes T and cutting inflows in spending G.
It can also balance against increases or decreases in outflow. If imports M increase, it can increase deficit spending. If imports M decrease, Congress can cut spending accordingly. Or it can raise taxes if the decrease seems to be permanent. If savers begin to save more, Congress can increase deficit spending.
Now, there are a lot of interesting consequences of the simple model I‘ve developed here. To begin with, if the government cuts back spending and there is no counteracting increase in export sales, or investment, or bank lending, the economy will move toward recession--depending on what is happening at the outflows.
Raising taxes drains more money out of circulation. So, if the tax money is not spent but held, that produces a surplus. And this may cause a recession and even a depression if not countered by increased exports and investments. It may even be countered by increasing bank lending, but this has a danger of producing a bubble in the economy if subprime loans are used and may be ineffective if businesses do not seek to borrow money because they see no increase in demand for their goods and services.
If business cuts back investing and sits on its savings, the economy will cut back toward recession and depression. If business does not see increasing demand for its goods or services and does not borrow money for expansion, then no new money is coming into circulation from bank loans.
This is why the Fed‘s QE (quantitative easing) by buying securities held by banks has not had any effect on growing money in circulation nor even caused inflation.
Banks do not lend out their reserves. They create money for loans out of thin air.
But banks cannot lend until borrowers come to them for loans.
If people and businesses just save and don‘t spend, the economy will slow down. After awhile they will have to spend their savings to survive, but when their savings are exhausted they are in deep trouble. They cannot grow savings to spend and invest if there is not continually new money coming in from government deficit spending or exports.
But it is always possible that there will be looney Congressmen who do not understand the theory of monetary flow who will put caps on government spending and borrowing, tying government's hands and thus disabling government from be able to deal with recessions and depressions by deficit spending.
Or a debt ceiling may prevent the Treasury from paying interest because it has to get money for interest by borrowing from banks with security sales. The government would default on servicing its debt. That would be serious. A lot of big banks might default because their interest stream is cut off while they play with derivatives, leaving them without enough money to back their position.
A lot of investors (many foreign) in US securities may not get their interest because Treasury has to borrow (with endless roll-overs) money from banks for it. Investors will pull their dollars out of US securities and may even start using their dollars to buy up assets and properties in the United States. This may cause inflation too if the government is already deficit spending.
There may also be looney Congressmen who will want to continue creating new money for programs beyond the point of full production and employment, and then cause inflation. But once everyone knows how fiat money should be used, those cases will be persuaded to back off.
Another way of putting it is , "How do we fill the pool without overflowing it?" That means we do not want (serious) inflation. Mild inflation, like 3% per annum, may be just enough to keep savers from sitting on all their savings for long periods and start buying goods and services, which keeps the economy going and growing to match population growth.
Fiscal balance isn't everything
Fiscal balance is making spending equal tax revenues. But seeking this reflects too narrow of a view of finances at the federal level.
There are instances where the level of inflows equals outflows, but unemployment is growing. This could come from steady population growth while money inflow and outflow are constant. That could lead to deflation.
In the case of population growth, increasing deficit spending may increase inflow of money to raise the level of money in circulation to a point where production may be increased with hiring of idle workers. At the point that full employment is again reached, inflows should be reset to match outflows. Deficit spending should be reduced.
Production may fall or fail to meet demand due to shortages in raw materials, or destruction of factories, or obsolescence of major products, like when typewriters were replaced by desktop computers, or buggy whips were obsolete with the advent of automobiles.
Industry will make adjustments in finding substitute materials or products, new factories will be built and put online. Workers will be retained to operate the new factories. Holding money inflow constant or slightly raising inflow may be needed temporarily to help the transition.
Balancing the budget only means balancing spending against taxes.
Making federal spending depend on taxes, means that as more and more money gets locked up in savings, there is less and less money in circulation. Deflation occurs. Deflation causes businesses to let go employees as demand for goods and services drops, reducing sales. More unemployed means further drops in demand, and business goes into a downward spiral of reducing employees and lowering prices to meet reduced demand.
Less money in circulation because government spending must equal tax revenues means less tax revenues. That means less government spending, and a downward spiral in the economy results.
States benefit from federal deficit spending, because it introduces new debt-free money into their economies which they are otherwise incapable of generating during recessions and depressions.
The focus on a balanced budget does not focus on having enough money in circulation to sustain full production and employment at stable prices.
So, simply making federal spending depend on taxes while ignoring a negative trade balance of exports against imports, or increasing saving while there is reduced investing, or lack of bank lending will lead to a deflated economy. So it is a bad idea to seek always balanced budgets at the federal level, when during deflations the federal goverrnment needs to create new money with deficit spending to get back to full production.
But hyperinflation need never occur.
Since the "national debt" has come up here, I will digress to show why that is not the problem everyone thinks it is for the taxpayers.
The "national debt" is effectively constituted by the total value of all the U.S. Treasury securities currently in existence. Right now it is figured to be approximately $18 Trillion in value. In 2010, which is the source of the facts in the above pie chart, the total national debt was $14.3 Trillion. It is continually growing.
The national debt can be divided into several categories according to the method of how their debt is dealt with: (1) marketable securities sold by Treasury to acquire dollars for deficit spending. (2) US Treasury securities bought by private, foreign investors and state and local governments. (3) Government series bonds held by federal government trust funds like the Social Security Trust. These are not marketable and the Fed cannot buy them; but it won't need to. All of these imply a liability of the government to pay the holder of them their face value on demand. But they are handled differently.
Each of these cases can be managed without taxpayer money.
Usually securities are sold at public auction at discount, so interest paid at maturity on them is the difference between the principal price at which they were bought and their face value.
What appears on the surface to be a serious problem with these securities and bonds is that their total value is enormous.
But our economy is ever growing along with our population.
Where will taxpayers get the money to pay them back? Will the economy collapse at some point when the debt becomes impossible to pay back? Will the economy collapse if we do pay them back? Will our children and grandchildren be responsible for paying off the debt?
That it seems to be a problem is because ordinary people are thinking about 'debt' here in terms they are familiar with.
A debt is an obligation you will eventually have to pay or be in default.
Furthermore when you take out a loan, you usually spend the money you get from the loan. And you have to work hard to earn money already in existence to pay back the debt.
But things are different with U.S. securities. The Treasury has unlimited power to create new securities as the need arises. And unlike your or my IOU's, the banks will accept these US securities as an absolutely safe investment. And the Fed has the power to create new government money in any quantity out of thin air and either spend or lend it.
But I have already indicated that in the case of securities for deficit spending, the Treasury just rolls over the debt at maturity of the securities by swapping new securities it creates for mature securities held by the banks plus paying interest (Newman, 2010). This just extends the maturity date to a new future date, and continues to do so with each swap. Actually instead of keeping dollars in a time deposit account, the dollars are represented by the security held in the bank's securities account at the Fed and paid back by the Fed at maturity in dollars.
And Treasury can get money for interest payments by also issuing securities and selling them, and then rolling them over forever and ever. So, there will never be a complete pay back of the principal to the banks, and the banks accept this, in return for all the perpetual free interest.
So, taxpayers don't have to worry about paying back the debt for deficit spending. It is not a true debt because it will never be paid back.
Deficit spending debt is only a relatively small portion of the national debt
In the above pie chart only 4% of the securities held were held still at US Banks and Savings Institutions. Because Treasury sells deficit-spending securities only to banks, this may indicate the upper limit to the number of active securities for deficit spending. Not much, no? That surprised me, but then I looked and saw that 9% of the debt to non-federal entities was securities held at the Fed, which was a large increase from previous years.
The remaining 87% is investor-held securities. Their money does not fund government operations or programs. The Treasury can only spend what Congress allows it to spend, and it will only borrow to cover deficits, which are authorized. Although investor-held securities technically are a government obligation to repay at maturity of the securities, they do not constitute borrowing to cover a deficit. The dollars given the government for the investors' securities are kept in "time-deposit accounts" (actually securities accounts) at the Fed--in savings essentially. They serve to prevent inflation by keeping money out of circulation.
In buying the securities (with money created out of nothing) from banks in Quantitative Easing, and now holding them, the Fed cancelled the government's debt to the banks. So, these securities held by the Fed are likely not active securities in the sense of being an investor debt owed to some non federal party. Those do not represent debt to the banks. More on that below.
Some believe that when the Fed buys the securities from the banks in Quantitative Easing or Open Market Operations by adding the money to the banks' reserves, that potentially will cause inflation by being used to support lending. But that money is being used to cancel the debt created by the banks in buying the securities from the Treasury with loans from the Fed. That means the debt on the books at the banks is erased, and the money used to buy the securities similarly vanishes, never to enter circulation.
In general, all repayments of debts extinguish the money lent by the banks. Ordinarily the money comes from circulation, and the repayment takes it out of circulation. But when the Fed buys securities with money it creates, but not yet in circulation, the money earlier lent and spent into circulation continues to exist, but the Fed's money vanishes with the canceling of the debt.
The money earlier 'lent' by the banks to the Treasury and spent into circulation is now debt-free. That money could potentially cause inflation, even from the time the Treasury spent it. Whether it will be inflationary depends on other factors, such as whether or not there is already full production and employment at the time it was spent into circulation.
The rest of the pie chart shows 87% of non-federal entities, who are private and foreign investors , or state and local governments, held these securities.
These securities are like time-deposits at the Fed, which contain the money available to return the principal plus interest (to be created out of thin air) at maturity.
That means .87 times $9.7 trillion are held as principal in time-deposit accounts, or $8.44 trillion. The money is already there to return! The government doesn't have to go to taxpayers for it.
Most accounts just say these are safe investments and that is why investors buy them as a safe place to park their dollars and earn a little interest.
What is not usually said is why the government offers these securities to these entities. I think the answer is that these securities are like sponges that soak up dollars that otherwise could be spent in the economy and possibly cause inflation.
Socked away in the time-deposit accounts, they are not in circulation where inflation could occur. That leaves more freedom for exports and deficit spending.
The debt ceiling uses a value of the national debt to constrain Congressional deficit spending by prohibiting any such spending that would make the national debt exceed the specified value.
We have already shown that there is no problem in managing the national debt. Generally the portion of the national debt due to deficit spending is a small portion of the national debt.
Furthermore it is handled, and has been so handled since 1791, by rolling over the debt with the Treasury swapping new securities it issues for the mature securities held by the banks and adding in the obligated interest. Or it may be paid off by the Fed buying the securities with money it creates out of thin air.
The greatest portion of the national debt is the securities held by private and foreign investors and state and local governments. These do not fund government spending. Only deficit spending authorized by Congress funds government operations. So, only large US banks hold the securities for deficit spending (or the Fed if it has bought them at public auction or in Quantitative Easing--which cancelled the government's debt to the banks on those securities).
The securities held by investors, on the other hand, are instead like CD's backed by time-deposits equal to the money used to buy the securities. The money is always there in time-deposit accounts to be returned to the investors when their securities mature. It is only spent on government operations.
There is only the matter of the interest. If the Fed manages the money return to the investors, it can simply create the obligated interest out of thin air.
If the Treasury returns them, it adds interest it borrows by issuing securities that are sold to get the money for the interest, and then rolling these over forever.
But if the debt-ceiling puts a limit on debt, it puts a limit on borrowing and paying the debt. And when over the debt ceiling, that means that Treasury cannot even roll over current and past debts with included interest, because it cannot borrow with securities to acquire the necessary interest money. That means the government then defaults on its debt. So, the debt limit creates a problem with the debt where there should be none.
That will force the banks to put their deficit-spending securities up for auction and have the Fed buy them back for the government. That will cancel the government's debt to the banks. The banks lose the interest money stream. But the deficit spending money is then debt-free.
Debt ceiling may be unconstitutional.
The Constitution says simply at Article I Section 8 that "Congress shall have the power ... to pay the debts... To borrow money on the credit of the United States." It does not state that Congress shall have the power to borrow money until Congress determines a limit beyond which it cannot borrow. In other words the power is absolute and only could be withheld or limited by a Constitutional amendment. A Congressional law cannot put limits on its powers to borrow or pay debts.
The problem is that the debt-limit is inappropriate because the so-called debt is no real problem. The debt limit may be even unconstitutional. What Congress can do is put limits on its own spending, since nowhere in the Constitution does it express that Congress has an absolute power to spend. It would be absurd to say so. It just can spend what it decides to spend. If that is the limit, it would not limit Treasury in servicing the debt by being able to borrow money from banks for interest. It would not constrain deficit spending as long as total spending is within the limit.
Why does the Fed buy securities?
We have already seen that the Fed buys securities, because the graph shows it holds some. We have indicated that when it buys them it cancels the government's debt to the banks or holders of them.
It usually buys them during deflations because that puts money for them in the reserves of banks holding the securities, making it easier for the banks to lend.
The Fed buys them also because it will use them to fight inflation, when it happens. So, it will keep securities that have matured until inflation occurs and then swap them with the Treasury for new securities of the same face value. (This is legal).
The Treasury at that point has its securities back and can extinguish them.
But if there is problematic inflation, the Fed will sell the new securities it holds to banks and investors to drain excess money out of the reserves at banks and circulation. That is one way it fights inflation. Inflation also is fought by raising taxes, encouraging buying of imports, encouraging increased saving by raising interest, which also discourages lending..
Government series bonds
What about the government series bonds held by the Social Security Trust and other government trust funds? Will taxpayers have to pay for them? No.
While the Fed cannot buy them, Treasury can simply borrow money to buy them by selling Treasury marketable securities to banks to get the money. This is just the same situation as with deficit spending.
Treasury will roll over the marketable securities the banks have bought when they mature. It will do this forever.
If at any time the banks want to get rid of the securities in exchange for money in their reserves, the Fed can buy the marketable securities to redeem them outright and cancel the government's debt to the banks. So taxpayers don't have anything to do here either.
Bunny, Arliss & Melissa Irwin (illustrator). (2013). The smart bunny's guide to debt, deficit, and austerity. Copyright is in name of Melissa Irwin. This seems to be self-published at some undisclosed location. But you can buy it from Amazon.com.
Keen, Steve (2011). Debunking Economics. London: Zed Books.
Newman, Frank N. (2013). Freedom from National Debt. Minneapolis, MN: Two Harbors Press.
Wray, L. R. (2012). Modern Monetary Theory. Houndsmills, Basingstoke, Hampshire, UK: Palgrave Macmillan.