The U.S. national debt currently stands at $32.91 trillion, and 10 months into this fiscal year, the U.S. government has spent $1.6 trillion more than it has collected in revenue. Those intimidating figures animate political battles that can shut down the government and even bring it to the brink of default. But the meaning of this money isn’t as simple as it seems. Five myths in particular deserve straightening out.
The first is that the government has to borrow in order to spend and run deficits. It’s the other way around. The government creates money (injects it into the economy) when it spends and destroys money (withdraws it from the economy) when it taxes. The government taxes variously to correct for negative externalities, to redistribute income, and to modulate aggregate demand; “raising revenue” is just a cover story.
A related myth is that the government needs to repay its debt. “Debt” is a misnomer; government debt is just money (or purchasing power) in another form. A $20 bill is a liability of the Fed, which makes it a liability of the federal government. A $20 bill never has to be repaid; it just is. Fundamentally, Treasuries aren’t much different.
That government debt never needs to be repaid doesn’t mean the government can or should create as much of it as it likes. Too big a pile of debt because of prior and ongoing budget deficits may be inflationary, as too much money chases insufficient goods and services. That will require some combination of monetary and fiscal tightening. A mountain of debt may indicate a government that is too big and intrusive in the economy for many people’s liking, an issue that can be fought out at the ballot box.
A third myth is that the Fed prints money when it does quantitative easing. The money printing happens when the government runs a budget deficit; QE just changes the form of that money.
QE is really just a debt refinancing operation of the consolidated government—that is, the government including the Fed—whereby it refinances one form of debt (government bonds or guarantees) into another (reserves). QE changes the composition of the (consolidated) government debt in the hands of the private sector, but it doesn’t directly add one iota of new purchasing power. For every dollar the Fed “pumps into” the economy by doing QE, it “sucks out” a dollar of assets. Conversely, quantitative tightening just returns assets to private sector portfolios, expunging reserves in the process.
Reserves are like bank notes: The Fed can withdraw them, but it never has to repay them as such. It looks like the government has to repay Treasuries, but this is an institutional artifact. In extremis, the Fed could convert all outstanding Treasuries into reserves, and it could maintain monetary control by it, rather than the fiscal authorities, paying interest on reserves.
Japan is the poster child for a miserable-looking fiscal picture. Yet, the Bank of Japan, the pioneer of QE, owns almost half of the stock of outstanding Japanese government securities and, at the same time, since 2016 has managed the 10-year yield, with some leeway, to be “around zero percent.”
It is precisely because the government can create money at will that the modern monetary and fiscal architecture has been designed to put shackles on its ability to do so: The creation of an “independent” central bank within the government, the central bank not allowing the government’s account with it to go into overdraft, the central bank not buying bonds directly from the government, and governments issuing debt securities rather than leaving their deficits in the form of reserves all serve that purpose. But what the government taketh away, it can give back. Faced with the need, it could loosen those shackles.
A fourth, and related, myth is that banks could, if so moved, “lend out” the excess reserves created by QE. Banks can lend these reserves to one another but they cannot turn them into lending to companies and households in the broader economy.
It isn’t just the government that creates money. Banks do, too. A fifth myth is that banks are just financial intermediaries “taking in” deposits and “lending them out.” Not so. Banks create money when they lend. For an individual bank making a new loan, it may not feel like this, because the first thing borrowers do is spend their money. If none of that money flows back into the same bank, its reserves at the central bank will decline by the amount of the loan. It will then probably want to attract deposits to “fund” the loan, but doing so will just top up its lost reserves. Bank lending for the system is entirely self-funding (so long as none of the money created leaks into bank notes).
The U.S. economy currently produces about $27 trillion of goods and services annually, a little more than the amount of federal debt held by the public and the QE-embracing Fed. The money needed to sustain this giant prosperity-generating machine comes from the government running deficits and from banks extending credit, with the Fed’s activities linking the two. Political debates and decisions currently are based on a befuddled grasp of how this monetary system works. The stakes for society are too high for that.B
The writer is a former vice chairman of S&P Global and the author of The Power of Money: How Governments and Banks Create Money and Help Us All Prosper.