Market Overview

Can a Government Run Out of Money? Part 1

The Federal Government has been handed a temporary reprieve by Congress: it won't be shut down just yet. That gives the Democrats and Republicans more time to haggle over which items to cut. The premise is that the government is “running out of money” as President Obama has put it so eloquently in numerous speeches. Let us first examine that claim and then move on to the real subject of debate. This is part one of what will be a two part series. Can a sovereign government run out of money? No. Indeed, a sovereign government neither has nor does not have money. The money government uses to spend is created as it spends. That might sound bizarre or even dangerous. But, in fact, on that score it is not so different from any other spender. Look at it this way. As economists who adopt the (French-Italian) “Circuit” approach have long argued, when a firm wants to spend it approaches a bank. The bank accepts the firm's IOU (called a loan on the bank's balance sheet) and creates its own IOU (in the form of a demand deposit). From the firm's perspective, the loan is its debt and the demand deposit is its asset. The bank “intermediates” because its IOU (the demand deposit) is more widely accepted in payment than is the firm's IOU. Of course, the firm is not going to hold the demand deposit since the whole object of borrowing was to spend. The demand deposit will then get shifted to the seller. Now, it is of course possible for the firm to finance its spending by using a sales receipt—a credit to its demand deposit and matched by a debit to the seller's account. But at the aggregate level, all the demand deposits were created as the accounting offset to loans. In other words, sales receipts in the form of demand deposits required some previous bank loan. At the aggregate level, bank “money” is created and therefore equal to bank loans—that is where bank money comes from. Can the bank “run out of money”? No. It creates the money when it makes a loan; and the purpose of this activity is to finance some kind of spending—on goods, services or assets. Can this money creation be “excessive” in the sense of causing prices to rise? Yes. Can it be “speculative” in the sense that it helps to fuel an asset price bubble? Yes. Can it be “foolish” in the sense that the borrower defaults and the bank ends up holding a worthless IOU? Yes. Can bank lending and thus money creation be constrained by government regulations and supervision? Yes. Finally, can—and should—the bank exercise self-restraint? Yes. So, just because we say the bank can always create money “out of thin air” by making a loan and creating a demand deposit that does not mean that it should lend “until the cows come home”, or that it does not face regulatory or self-imposed constraints. Ultimately, good banking practice requires good underwriting—to ensure it does not end up with too many trashy IOUs; and from the macro perspective, government wants to limit bank “money creation” to finance spending in order to prevent inflationary conditions in markets for goods, services and assets. Almost everything that has been said above about the finance of the spending of a private firm applies to a government. Government spending occurs simultaneously with a credit to a private bank account—that is to a demand deposit at a bank. The offsetting liability on the government's books is a credit to the bank's reserves at the central bank (which is the “private” bank's asset). The government cannot “run out of money” because the “money” is created when it spends. I have detailed in a previous blog how the government actually does this—following rules for spending that Congress, the Treasury, and the Fed have worked out. Government spending and hence “money creation” has all the same potential drawbacks listed above (most importantly, inflationary consequences when excessive), save one. A private borrower might fail to make payments on loans through no fault of his own. Of course, there are also deadbeat borrowers who choose not to pay. But private firms (and households) need income, or saleable assets, to raise funds to pay their debts. Sovereign government is somewhat different. We usually say that its “income” is tax revenue—somewhat different from wages or profits since taxes are at least in some sense discretionary. Further, the government's potential “customer base” is the whole economy and potentially all economic activity. However, that really does not get to the more important difference: government is the sovereign issuer of the currency. Next week we will examine that topic and then move on to the political agenda underlying the deficit and debt limits debate.

Posted-In: Economics

 

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