I often hear on the airwaves that the United States government is broke. You might get some reference to Greece and the Eurozone or maybe even the classic comparison of the government to a household. On face value, these comparisons seem rather valid. If no household can continually spend more than its income, why can the federal government? Unfortunately, the economic reality couldn’t be further from the truth.
Most of my readers (or anyone that casually reads the economic blogosphere) have probably heard many arguments against the government-household analogy from various economists, most notably Paul Krugman. So I thought I would approach this issue from a different angle, specifically a Monetary Realist/Modern Monetary Theory framework. The fact is, understanding that the US government is a currency issuer and the institutional structure of the US monetary system is vital if you want to understand monetary and fiscal policy.
When thinking about this issue, we must consider two institutions, the US Treasury and the Federal Reserve. The US treasury is responsible to enacting fiscal policy, i.e managing the tax system and selling bongs to obtain funds for spending. The Federal Reserve is responsible for monetary policy, using a variety of methods that ultimately serve the needs of private banks (think “lender of last resort”).
The US government, specifically the US Treasury, uses operational accounts at the Federal Reserve. So in a sense, the Federal Reserve is the banker to the US government. It’s through these accounts that the US Treasury settles all of its transaction (in terms of taxing and spending) using bank reserves, a form of outside money i.e money created outside the private sector. However, the US Treasury must first obtain funds from the private sector in the form of inside money, i.e money created inside the private sector, before it can settle the funds in its reserve account. It does this by crediting the bank accounts of recipients. As L. Randall Wray puts it, “A sovereign government spends by crediting bank accounts of recipients; it taxes by debiting them. A budget deficit means that credits exceed debits.”
So fiscal policy, in this case Government taxation, is best though of as a simple redistribution of inside money. When the US Treasury taxes and procures funds, it simply redistributes pre-existing inside money from the private sector. Cullen Roche provides a useful illustration:
When the US government taxes Paul, Paul pays with bank deposits or inside money. This inside money provides a credit to the Treasury’s Treasury Tax & Loan account at a commercial bank. The Treasury will settle this payment by having the Fed credit its account in what is called the Treasury General Account (the Treasury’s account at the Fed). This flow of funds from Paul allows the Treasury to then spend a bank deposit into Peter’s account. From start to finish, this process results in inside money in (taxation) and inside money out (government spending).
The important thing to think about here is that, although the US Treasury must collect fiscal receipts in order to spend (legally speaking), it isn’t constrained in its ability to obtain funds. In theory, the US government could utilize the Federal Reserve to create more money and finance the spending. The US government can’t actually “run out of money” as many politicians and journalists would have you believe. This is the key difference between the government and a household. A household or business are always limited in their ability to obtain funds. There is an actual solvency constraint. The same can be said of Greece and other countries in the Eurozone. Because of the structure of the Eurosystem, Greece isn’t a currency issuer and the ECB is essentially a foreign central bank. Again, there is a solvency constraint.
This process questions the very purpose of taxation. Taxes are often assumed to fund spending. But as it can be seen, the government doesn’t need taxes, it can just use the Federal Reserve (or any central bank) as a source for funds. Instead, the role of taxation is to control aggregate demand and inflation. When the government spends money, that spending will jump around the economy through a large number of transaction and when you have a lot of money chasing too few goods, you get inflation. But when the government taxes, that takes inside money out of the private sector, controlling aggregate demand and lowering inflation. Warren Mosler explains further:
The government taxes us and takes away our money for one reason – so we have that much less to spend which makes the currency that much more scarce and valuable. Taking away our money can also be thought of as leaving room for the government to spend without causing inflation. Think of the economy as one big department store full of all the goods and services we all produce and offer for sale every year. We all get paid enough in wages and profits to buy everything in that store, assuming we would spend all the money we earn and all the profits we make. (And if we borrow to spend, we can buy even more than there is in that store.) But when some of our money goes to pay taxes, we are left short of the spending power we need to buy all of what’s for sale in the store. This gives government the “room” to buy what it wants so that when it spends what it wants, the combined spending of government and the rest of us isn’t too much for what’s for sale in the store
As it can be seen, currency sovereignty really does matter when we analyze the US economy or any economy that has a central bank. So when David Stockman says that the “we’re broke” he doesn’t know what he is talking about and he is engaging in political rhetoric. Unfortunately, the same can be said of almost every politician on the right (and many on the left as well).
Understanding the Modern Monetary System: (To get a more detailed picture of Monetary Realism, read this very detailed paper by Cullen Roche. It’s where I got most of my information when writing this post)