Introductory Series: The Monetary System – US Currency Part 3

Morning everyone.

We will continue where we left off with a look at budget deficits, surpluses and the national debt. Previously, we’ve discussed US Dollars, what they are, where they come from, how they enter and leave the US economy, and US paper currency. In case you’ve been linked to this particular article, here is the series so far:

Introductory Series: The Monetary System – US Currency Part 1

Introductory Series: The Monetary System – US Currency Part 2

Introductory Series: The Monetary System – US Paper Currency

Also, let me restate the purpose of this series. The purpose of this introductory series is two-fold: Firstly, for those students considering economics as a major, the series will give you a solid understanding of the basics from which macroeconomic reality flows. In other words, from the get go, you won’t fall for mainstream fantasy, and then one day, obtain an influential position in government where you will create recessions and high unemployment for a living and then deny responsibility. Secondly, for the general public and interested laypersons who do not wish to be economists, but rather, who do wish to obtain a firm grasp on the basics of how federal spending and the monetary system actually works. Following today’s discussion, we will then take a look at other aspects of the monetary system, including banking operation and central bank operations, as well as a look at how the monetary system applies to Social Security. Let’s get started.

The Fallacy of Composition

The average person is inundated by politicians and the media with an analogy drawn between household budgets and the federal budget in order to facilitate a complete misunderstanding of how the monetary system works. We hear that the federal government has no money of its own, so like a household, it must have an income. Therefore, the federal government must tax to fund its spending. If the federal government wants to “live beyond its means”, spending more than its income, then it must do like households do and borrow “money”. The government borrows by issuing treasury bonds. Just like a household, when the federal government persistently borrows, it goes deeper and deeper into debt.

If you’ve read my previous discussions in this series, then you know that the household analogy is entirely false, because there is no gold standard any more. The possible reasons for why politicians and the media would want to spread anti-knowledge to the public we will not discuss here. There are two areas in economics: the microeconomy and the macroeconomy. They are vastly different. Microeconomics tries to understand the effects individual decisions have on the economy. In other words, microeconomics examines the question: “Exactly how many angels can dance on a pinhead?” and then tries to apply that reasoning to the whole economy. Macroeconomics concerns itself with the economy on aggregate. Generally speaking, the two aren’t compatible with one another, which is why mainstream economics is a failure. The micro to macro view leads people to believe in nonsense, such as the idea that the federal government can save its way out of a recession. The household analogy seeks to apply the micro viewpoint to the macro viewpoint, and, in doing so, falls victim to the Fallacy of Composition. Let us briefly examine this fallacy as it relates to saving.

Here we have a fellow named Bob. Hi, Bob! Bob makes $25,000 per year. Bob examines his budget and discovers that he is spending far too much and needs to save money. Bob takes a hard look at his expenses, trying to find cuts to pay for other things. Sound familiar? Bob discovers that his daily Starbucks habit is out of control. He is forking over $50 per week on lattes when he needs that $50 for groceries. So, Bob decides cut out Starbucks altogether. Bob does so, and saves $50. Good for Bob! Bob is saving money. But, there’s something else about Bob that, for him, makes this $50 savings possible, but not possible for the federal government. Bob is a mere user of the federal government’s US Dollar. He cannot manufacture more dollars on the fly. Unlike the US government, Bob actually needs and income to fund his spending – So does everyone else in the private sector.

Let us now assume that Bob took to the media, extolling the financial virtues of cutting out Starbucks, and everyone else in the US who visits Starbucks got wind of Bob’s plan to save money. Everyone thinks Bob’s plan is just awesome; so much so, that everyone else decides to cut out Starbucks altogether to save money. Now everyone is saving lots of money. Good for everyone! Not good for Starbucks and its employees.

If everyone stopped visiting Starbucks in order to save money, Starbucks would lose its income and go out of business, firing all of its employees too. Every, single person who used to work for Starbucks would now be unemployed, and since they have no income, they would reduce their spending. Now, even more people are not spending at other businesses. Increased savings on aggregate means decreased consumer spending, and thus, increased unemployment. In other words, the United States as a whole, can’t save its way out of a recession. Should the federal government as the currency-issuer attempt to cut spending and save along with the private sector, much needed additional dollars necessary to increase consumer spending and decrease unemployment, would not be entering the economy, and the recession would only deepen. The household analogy falls prey to the fallacy of composition, because the micro level does not apply to the macro level. Since the federal government is the exclusive manufacturer of US Dollars, budget deficits are the only means to add more new dollars to the US private sector. Deficits are not “short falls” for the federal government, but rather, they are “deposits” of US Dollars into the private sector.

Federal Budget Deficits Properly Defined

A federal budget deficit is errantly defined by the mainstream as when the government spends more than its income. This is simply not true, because, at no point in time, does the federal government have an income. Factually, a federal budget deficit is the difference between the number of US Dollars manufactured and spent by the US government and the number of US Dollars destroyed afterwards through taxation in any given fiscal year. Mathematically, we can express a budget deficit as (G – T > 0), where government spending (G) minus taxation (T) is greater than zero. For the sake of continuity and clarity, let’s briefly review concepts from our previous discussion in part 2 of this series.

Review of US Dollar Creation

In the United States, the currency manufacturing process begins when Congress authorizes spending for various federal initiatives, which the mainstream refers to as “the federal budget”. Once the President has signed the “budget”, the currency manufacturing process is complete. If the total authorized is $4 trillion, then $4 trillion has been manufactured and is now awaiting disbursement. Disbursement is the act of paying out or disbursing money, which in the case of the federal government, is the paying out of “money” that the government created, through the process known as federal spending.

The US Dollar manufacturing process does not involve printing machines at the Bureau of Engraving and Printing, nor does it involve coin stamping by the US Mint. There is no storage facility for the $4 trillion manufactured by Congress. The manufacturing of US Dollars means, quite simply, that Congress has authorized the US Treasury to enter various bank accounts and credit those bank accounts with no more than $4 trillion within that particular fiscal year, unless otherwise instructed to increase that amount. To understand the simplicity of the concept, let us use a more familiar, but imperfect, example.

Apple manufactures and then sells iPads. Let us assume that Apple decides that this year it will manufacture 10 million iPads. It then authorizes its production facilities to begin manufacturing 10 million iPads, which they do, and Apple then disburses (ships) those iPads to retailers.

In a similar way, the US government manufactures and then issues US Dollars every year. It is the constitutional duty of Congress to ensure that the US government will supply the US domestic economy with US Dollars and also determine the appropriate level of taxation for that particular fiscal year. Each year, Congress must, therefore, decide how many dollars the federal government will manufacture and how many it will reclaim through taxation and destroy. Then, when approved by the President, the US Treasury is authorized to begin disbursements of those newly manufactured US Dollars. In the case of US Dollars, manufacturing is not the physical creation of a product, but rather, it is the decision to set the level of US Dollar injections into the private sector to a fixed amount for that particular fiscal year. Congress has the authority to manufacture and then disburse an infinite number of US Dollars. So, when Congress sets the US Dollar manufacturing output to a certain level in any given fiscal year, Congress is actually setting a limit on the number of US Dollars it will allow to be created and then disbursed by the US Treasury.

The Function of Federal Budget Deficits

On a daily basis, the federal government is crediting bank accounts with newly manufactured US Dollars (federal spending), and it is also removing US Dollars from reserve accounts (federal taxation) that the US government previously manufactured and spent. All federal spending comes before federal taxation; not the other way around. If the number of US Dollars manufactured and then disbursed into the economy are greater than the number taxed out of the economy, then a federal budget deficit exists. Operationally, the reality is that a federal budget deficit is income for the private sector. In order to demonstrate this reality, we come to the point in our discussion where we must clarify sectors and familiarize you with the difference between the US private sector and the rest of the world. The point of what follows is not to inundate you with math, but to demonstrate to you that we aren’t dealing in guesswork and thus, we can clarify the reasons why the monetary system works in the opposite way than that which the mainstream tells you. Do not panic. You won’t be asked to calculate anything.

Sectoral Balances

There are three major sectors to the US economy:

(G – T) = the government sector

(S – I) = the US domestic private sector (you, me, Walmart)

(X – M) = the external, or foreign sector (the rest of the world)

that when assembled, take a form of what is known as the Sectoral Balances equation:

(G – T) = (S – I) – (X – M)

How we derive the equation is pretty much straight forward once you know the source of the equation.

The Flow of Funds Accounts

The Flow of Funds Accounts provide a sectoral viewpoint of the flow of funds through sectors within a particular economy. In the United States, the Federal Reserve publishes the information for the different sectors within the US economy. As this is an introductory series, it is only important to understand the following:

The total sources of funds for each sector of the economy must equal the total uses of those funds.

The National Accounts and Deriving the Sectoral Balances Equation

The Flow of Funds Accounts, combined with the National Accounts, provide us with a basis to derive the Sectoral Balances equation. Where the Flow of Funds Accounts details the flow of funds through the sectors of the economy, the National Accounts separates the economy into categories of spending.

We can derive two linear equations based on this information. The first equation expresses the sources of total spending of national income, also known as “GDP” while the second expresses the uses of national income (GDP). Let us construct the first equation.

GDP = C + I + G + (X – M)

The above linear equation states that the total national income (GDP) is equal to consumption (C) plus investment (I) plus government spending (G) plus exports minus imports (X – M). When the right side of the equation is added together, the result equals aggregate demand.

Let us now construct the second equation:

GDP = C + S + T

The above linear equation expresses the total uses of national income (GDP): consumption (C) plus savings (S) plus taxation (T). When the right side of the equation is added together, the result is the total usage of national income (GDP).

As we can see, both equations equal GDP (national income) and as we remember from the Flow of Funds Accounts section: The total sources of funds for each sector of the economy must equal the total uses of those funds.

Thus, we can express both outcomes as one equation:

C + I + G + (X – M) = C + S + T

To derive the sectoral view, we then cancel like terms, which in this case is (C), from both sides of the equation and in doing so, we derive:

I + G + (X – M) = S + T

The above expression now reveals the three sectors in the economy. Two sectors are not yet clarified by pairing, namely the government sector and the domestic private sector. To clarify, we can easily arrange the equation, to derive:

(I – S) + (G – T) + (X – M) = 0

Where investment minus savings (I – S) is the domestic private balance, plus government spending minus taxation (G – T) which is the government balance, plus the external balance; exports minus imports (X – M). The three sectors when added together must equal zero, because the sum of all income must equal the sum of all the uses of income. Hence, the above equation is the Sectoral Balances equation.

We recall the fundamental macroeconomic rule: Somebody’s spending is somebody’s income. We must also understand that the same applies across all three sectors of the economy. Each individual sector does not have to be in balance. However, all three sectors, when considered together, must, because on the macroeconomic level of the economy, any of the three sectors can be in deficit or surplus, and those deficits and surpluses must cancel each other out.

In its current form, (I – S) + (G – T) + (X – M) = 0 does not clarify the federal government as the currency issuing authority which funds the other two sectors via the process of net spending (deficits). Again, we rearrange the equation and can express the Sectoral Balances as:

(G – T) = (S – I) – (X – M)

The above linear equation states that government spending (G) minus taxation (T) will equal savings (S) minus investment (I) minus exports (X) minus imports (M). In general terms, whatever the federal government spends minus taxation, that exact amount will be deposited in and distributed between the domestic private sector and the external sector as income. We can now aggregate (put together) the right side of the equation using brackets and define two sectors:

(G – T) = [(S – I) – (X – M)]

The government sector = The non-government sector

or quite simply put: The government sector’s deficit is the non-government sector’s income.

The Operational Reality of Federal Deficits and Surpluses

Federal spending is the depositing of US Dollars into the economy and taxation is the withdrawal of US Dollars from the economy. If the US government runs a budget deficit, depositing more US Dollars into the economy than it withdraws, then what remains is a net savings for the non-government sector. A way of looking at this concept is to consider deposits and withdrawals from your personal bank account. When you deposit and then withdraw money from your savings account, if the total amount deposited is greater than total withdrawals, then the remainder is a savings, or (D – W > 0), where deposits (D) minus withdrawals (W) are greater than zero. If less than zero, (D – W < 0) the result is a deficit. Similarly, the federal government makes deposits and withdrawals into/out of the US economy, except, in this case, the federal government is the income source for the entire US economy, as demonstrated by the reality that the US government issues all US Dollars and by sectoral balances equation.

[(S – I) – (X – M)] is 100% financially supported by (G – T) and, thus, entirely dependent upon (G – T) manufacturing US Dollars, and then giving it those new US Dollars.

So, when we discuss federal budget deficits, what we are actually discussing is a stream of income (flows) into the US private sector that will result in US private sector savings (stocks). The US government itself cannot have an actual deficit in terms of US Dollars, because it never has an income in US Dollars. It manufactures all of the US Dollars.

When we discuss federal budget surpluses, what we are actually discussing is the withdrawal of US Dollars from the non-government sector that will result in US private sector deficit. The foreign sector (X – M) plays a crucial role here.

Because international trade exists, the US both exports its own goods and imports foreign goods. When the US government manufactures US Dollars and spends them, some of those dollars flow out of the US and into the rest of the world (X – M) through imports. Imports means that the US is buying foreign-made goods and paying for them with US Dollars, because the rest of the world is selling its goods to the US. If imports (M) exceed exports (X), then there exists what we call a “current account deficit” for the US. So, if China has $3 trillion, then the US has $3 trillion worth of Chinese goods. Since $3 trillion flowed into Chinese hands, that is exactly $3 trillion that the US domestic private sector cannot spend in order to decrease unemployment. If there is a current account deficit, more US Dollars are flowing out into the hands of the rest of the world than are flowing back into the US, and so, the US government simply cannot run a budget surplus without causing a recession in the US domestic private sector.

As budget deficits are income for the US domestic private sector, then if there is a current account deficit in conjunction with a federal budget surplus, US Dollars are flowing out of the US domestic private sector in two directions:

1.) into the rest of the world through imports

2.) back to the US government through taxation

The result, then, is that the total amount of US Dollars circulating in the US domestic economy is shrinking and the US government would be forcing the US domestic private sector to run a deficit in order to prop up a large economy. What this means, is that the domestic private sector must rely on bank credit to continue spending, which will result in the increasing indebtedness of the domestic private sector. When the US domestic private sector can no longer take on more private debt, consumers will reduce their spending. When this occurs, businesses will begin losing income. As businesses lose income, they will lay off workers, unemployment will rise and a recession will occur. When the unemployed seek assistance from welfare and unemployment insurance because few jobs are available, the federal budget surplus will automatically become a federal budget deficit.

In very simple terms, the reality is that the federal government’s deficit is not the US private sector’s deficit and a federal budget surplus is not the US private sector’s surplus. Since there exists a current account deficit, then at all times, to ensure persistent full employment and a stable economy, the federal government must run budget deficits targeted at full employment. Expanding federal budget deficits are necessary up to the point of full employment, which is the point of maximum production capability; a condition we call “macroeconomic efficiency”. If federal deficits persistently exceeded the real production ability of the US economy, then inflation would occur.

Simply put, deficits that are too high can be inflationary and deficits that are too low result in unemployment. That being said, if the US is running a current account deficit, importing more than it is exporting, then federal budget surpluses will always result in high unemployment and recessions.

We now understand that federal budget deficits are income flows into the US private sector. Next we will examine those cumulative income flows (all deficits totaled together) which are a stock that the mainstream calls “the national debt”. It is not a debt whatsoever. In reality, the national debt is actually the stock of private sector savings.

The National Debt

The US national debt does not exist. Yes, there is a running total that is kept, and that total is regularly waved in the face of the public as a massive debt by politicians, the media, various websites and the stupid “debt clock” as the US government debt crisis. In reality, the so-called national debt is nothing more than a bunch of savings accounts held at the Federal Reserve that are earning interest.

As we’ve previously discussed in this series, US Treasury bonds do not fund federal spending, because, again, there is no gold standard that would necessitate keeping the level of currency in circulation consistent with the level of gold reserves.

To review, the gold standard was a regime where the US government agreed to peg its infinite US Dollar to a finite commodity (gold) in order to needlessly give the US Dollar “intrinsic value”. The government accomplished this by fixing the value of a dollar to a certain amount of gold. In order for the gold standard to work, it required that the US government agree to exchange gold for US Dollars upon demand. In order to do that, the US government had to maintain gold reserves, so it could actually exchange gold for US Dollars. While the US government could never run out of US Dollars, the gold standard meant that the US government could run out of gold. So, to ensure that it couldn’t run out of gold, it had to limit the number of US Dollars in circulation to the gold supply. The way the federal government did that was through taxation.

By taxing some US Dollars and then spending them, the amount of currency in circulation remained consistent with the gold supply. Thus, by spending tax dollars, no extra currency was added. Now, if the federal government wanted to spend more than it collected in taxes, it had to offer treasury bonds. The US government would offer these bonds and investors voluntarily purchased them. In doing so, the US government could spend these voluntary contributions as well as the tax dollars, so, again, the amount of currency remained consistent with the gold supply. In the free-floating, non-convertible fiat regime that we have today, the US government has no gold reserves to defend through taxation and borrowing, and so, it does not tax or borrow to fund its spending. To repeat, you must understand that during the gold standard, the federal government had to ensure that the amount of currency in circulation was in keeping with the amount of gold it had in reserves. If it did not do this (tax and borrow to fund spending) and persistently increased the number of US Dollars in circulation, then there would be more dollars than gold available (in other words, “printing money” to fund spending), and when people demanded gold for their dollars at the fixed exchange rate, the federal government could run out of gold. This is one reason why the term “printing money” today makes no sense. The second reason is because the US government does not print cash to fund its spending. Dropping the gold peg and moving to free-float fiat entirely changes how federal spending works.

Treasury Bonds in a Fiat Regime

US Treasury bonds only serve two functions in a fiat currency regime:

1.) They assist the Federal Reserve in conducting monetary policy

2.) They provide risk-free, interest-bearing investments

As to the first, the Federal Reserve obtains bonds through open market operations and then uses the treasury bonds to conduct reserve drains. Why then does the Fed drain reserves? It does so in order to defend its target interest rate. As we will discuss later on in the series, banks that are short of reserves will seek reserves from banks which have excess reserves. This competition threatens the Federal Reserve’s target rate, and the Fed must intervene to stop the competition, or else it will lose control of monetary policy.

By taking treasury bonds and replacing the excess reserves with those bonds, banks hold less liquid reserves. So, if there are less reserves, then the interbank competition subsides, and the pressure on the Fed’s target rate is attenuated. That’s it in a nutshell. In a fiat currency system, the US Treasury issues bonds, not to conduct fiscal policy, but to help the Federal Reserve conduct monetary policy. The second reason that the US Treasury issues bonds in a fiat currency system, is because bond markets demand bonds, corporations like to manage their risk with public funds, and people generally like the idea of having a safe place to put their dollars and earn some interest, so Congress submits to the demand.

Since a US Dollar doesn’t pay interest, the US government manufactures a special US Dollar that does pay interest, called a US Treasury bond. To purchase a US Treasury bond, the first requirement is that you have the US Dollars on hand to buy it. So, first the US government manufactures and then spends US Dollars into the economy. Once you get ahold of some of these dollars, then you have the option of buying the special US Dollar that pays interest which the US government also manufactures and offers to you. As commercial banks like Chase offer you savings accounts to open, the US government offers you a savings account that you can open. But, this savings account is more like a bank certificate of deposit. You buy the certificate, your dollars sit unspent in an account, and they earn interest, all managed by the US government.

So, let’s assume that you do have the dollars necessary to open a savings account with the federal government. The Federal Reserve will shift those dollars from your bank’s reserve account held at the Federal Reserve, to the savings account, which is called a “securities account”, and which is also held at the Federal Reserve. Your dollars will then sit in this account earning interest. When the time comes, the Federal Reserve will shift the dollars in your savings account back to your bank’s reserve account and then via keystrokes, it will type into your account the correct amount of interest owed to you. The interest payment is nothing more than US Dollars typed into existence. So then, what of China?

Recall our discussion on international trade. China is not the United States, therefore, China has no authority to manufacture and spend US Dollars. Only the US government has such authority. So, China is just like any US household in terms of US Dollars – If China wants some US Dollars, China will have to earn them. It does so by selling goods to the United States in exchange for US Dollars. If you are having a hard time believing that, then I encourage you to visit any Walmart and look for goods on the shelves with the label “Made in China”. How did those Chinese goods get there? China sold them to Walmart in exchange for US Dollars, and now, Walmart is offering to sell those Chinese goods to you in exchange for US Dollars. The more China sells to the US, the more US Dollars China earns. What then can China do with all trillions of these dollars? It can only do a few things:

1.) China can exchange the US Dollars for another currency at its own expense.

2.) China can spend them in the United States, opening factories or buying goods.

3.) China can put them into savings here in the United States at the Federal Reserve.

So, why does China hold so many US Treasury bonds? Because of the choices available, China chose to stick its earned US Dollars into savings. China isn’t lending the “broke” US government money, because the US government cannot go broke and China cannot manufacture US Dollars. China is merely earning US Dollars and then saving them at the Federal Reserve. Now, with a clear understanding of what is actually going on, here then is a summary of parts 1, 2, and 3 of our discussion on US currency:

The US Dollar only exists in three forms:

1.) Cash

2.) Numbers in reserve accounts

3.) Numbers in securities accounts

and when you add up all three together, the total equals the US national debt, to the last penny.

Cash + Reserves + Securities = The US National Debt

Since we know that only the US government manufactures US Dollars, and, since we understand that the so-called national debt is only in US Dollars, then we also understand that the national debt is not a debt at all. It is, in fact, the national savings.

So, when Hillary Clinton says that she will not add one penny to the national debt, what she is saying is that she will not add one more penny to the national savings. That’s pretty stingy. Furthermore, Hillary is saying that she will not add a single dollar of income to the US domestic economy. That’s just great, isn’t it? In short, Hillary Clinton’s economic plan is:

“I will force the US domestic private sector deep into private debt. I will also ensure that high unemployment is sustained. If you elect me as President, I intend to create a recession. And, as an added bonus, I will drive the national income towards profits and away from working men and women. Now, what do you think of that?”

Lastly, let’s look at how the US government actually “pays off” the so-called national debt.

As mentioned moments ago, when you have the dollars necessary to open a savings account with the federal government, the Federal Reserve will shift those dollars from your bank’s reserve account held at the Federal Reserve, to the savings account, which is called a “securities account”, and which is also held at the Federal Reserve. When the time comes, the Federal Reserve will shift the dollars in your savings account back to your bank’s reserve account and then via keystrokes, it will type into your account the correct amount of interest owed to you.

Now you know how to “pay off” the national debt.

The Federal Reserve will move $20 trillion held in savings accounts back to reserve accounts and type the interest into existence. “Debt” paid. The operation is no different than you moving $100 from your savings account to your checking account. No tax dollars are needed for this operation, because, as we now understand, in a fiat system federal taxes don’t fund any federal spending. It’s as simple as shifting the entire balance back to a reserve account.

The reason why the economy collapses when the US government tries to “pay off” the national debt, is because it raises taxes and runs a surplus before it conducts the shift from savings to reserve account. Where the shift itself would not result in any economic problem whatsoever, politicians find it necessary to create an economic depression first, before shifting the dollars. And history demonstrates this reality.

There have been seven budget surpluses in US history, starting with Andrew Jackson and ending with Bill Clinton’s 1999 surplus, and each time shortly thereafter, a depression occurred.

This concludes the US currency section of the introductory series.