Economics: How (and where) is Money Created?

Smoke-mirrors-001

If you hear someone compare Uncle Sam’s budget to that of a family, you can be confident that he or she hasn’t a clue about budgets or the way that our monetary system works.

Since I have every reason to believe that President Obama is an intelligent and informed person, I wonder how it is that he has, on more than one occasion, suggested that a family budget and Uncle Sam’s budget are alike.

“Families across the country are tightening their belts and making tough decisions. The federal government should do the same.”

— President Barack Obama, 2010 State of the Union

When a President delivers a speech, many hands touch the text. A speechwriter prepares a draft, and this draft circulates throughout the relevant departments of government for comments. The speechwriter is responsible for collating all the comments and forming a coherent narrative, which is sent out again for review.

I have read in the blogs and essays of knowledgeable economists that the President’s economic advisers, from the Council of Economic Advisers for example, would strike remarks comparing Uncle Sam’s budget to a family’s budget or similar foolish remarks from the President’s speeches, and his political advisers would put them back.

The sentiments seem plausible to uninformed voters, and they have been repeated so often by uninformed or dissembling politicians and pundits that they form a part of common sense and common knowledge.

Nearly all economists know that these ideas are false.

Indeed, it is a commonplace of politics, mostly but not exclusively on the right, to assert that Uncle Sam should live within his means and not be borrowing so many billions, even trillions of dollars. Uncle Sam, this line of thinking goes, may run out of dollars in the future, and our children and grandchildren will have to pay for our selfish profligacy.

Nearly all economists know that these ideas are false. Uncle Sam issues his own currency, in which he contracts obligations, borrows, taxes, buys jet planes, pays park rangers, and everything else.

Uncle Sam cannot run out of his own dollars. In this, he is different from every other participant in the US economy.

All the rest of us, families, businesses, state and local governments, use Uncle Sam’s money, and we have to get it somehow. He, however, can always meet any of his obligations, and he does not have a pile of dollars in the basement of the Treasury Department on 15th Street near the White House to which he adds tax dollars and borrowed dollars and from which he removes dollars to pay what he owes.

Not only does our debt not burden our children and grandchildren, if we chose to leave our T-bills, which are assets, to them, we are giving them wealth. Uncle Sam borrows mostly from us, his citizens, and, in return, he gives us bonds recognized by financial experts as the safest assets.

The Fed does business by changing bits and bytes in its computers.

Uncle Sam taxes and borrows for historical and legal reasons, but not because he has to in order to get the money he spends. There is a law, somewhere, that requires the Treasury to match the sum of tax income and borrowing to its total spending. The law is unnecessary, but it exists. Uncle Sam must keep the money entering his right pocket equal to the money leaving his right pocket.

But Uncle Sam’s right pocket, the Treasury, is not all there is to the government. The Federal Reserve Bank is Uncle Sam’s left pocket. When the Fed buys Uncle Sam’s bonds from Wall Street banks, it creates the US dollars it needs and credits those banks’ accounts at the Fed.

There is also a law that prevents the Fed from buying T-bills directly from the Treasury.

The Fed doesn’t do this by printing money. Nor does it unprint (?) money when it issues bonds instead of buying them. Indeed, printed currency and minted coins form a fraction of the entire money supply, however measured. The Fed does its business by changing bits and bytes in its computers. These days most of the world’s transactions are electronic in this way.

Uncle Sam doesn’t ever have to pay anyone back.

Consider a T-bill that the Treasury has sold to someone. The Treasury increases its cash account and increases its T-bill obligation account by the same amount. Eventually, the Fed happens to buy that particular T-bill. It increases its T-bill asset account and increases the seller’s account with new money. Really, the Fed just changes some bytes in the seller’s account with it.

Now that particular T-bill shows up as an obligation of the Treasury in an account on the Treasury’s computers and as an asset in an account of the Fed’s computers. The public has been made whole. It has the same amount of money, along with some interest, as it had before the Treasury issued the T-bill. Uncle Sam doesn’t have to pay anyone back for the money that purchased that T-bill.

Strangely enough, the Fed keeps that T-bill as an asset on its accounts, and the Treasury pays the interest on the T-bill to it. The fancy name for these payments is seigniorage. That is, the profit the sovereign earns for issuing currency. At the end of the year, the Fed returns the interest to the Treasury as the Fed’s profits from its operations. Once the T-bill matures, the Treasury debits its cash account and the Fed increments its cash account.

All of these odd transactions by which Uncle Sam transfers funds from one pocket to another have nothing to do with the public or the circulation of money in the public sector.

It is actually a bad idea for Uncle Sam to tighten his belt when everyone else is doing so.

Why doesn’t Fed Chair Janet Yellen ask the clerks in the New York Federal Reserve Bank to stamp the T-bills they buy with a big PAID IN FULL and truck them to the Treasury Department on 15th St. in Washington? Professionals I have asked about this say “A good question,” but they don’t tell me why the government doesn’t consider that T-bills it has bought from the public are paid off.

The government knows the total amount of all the debt it has issued to the public that has not reached maturity, and it knows the total amount of all the debt it has issued to the public minus what it has paid back. The first is the number that shows up in the press to be tut-tutted about, but the second, much smaller number, is the amount of outstanding debt.

Unlike every family, every business, and every state or local government, the Fed never has to get the funds it uses to buy T-bills from anywhere or anyone. Its ability to create its funds is not connected to the state of the US economy.

Uncle Sam, both pockets, doesn’t have to get the money he spends from anyone either. If any politician or policy maker tells you that Uncle Sam should tighten his belt or he may run out of money then you should ignore the policies and laws he recommends because they will be ineffective if not harmful.

As a matter of fact, I believe it is actually a bad idea for Uncle Sam to tighten his belt when everyone else is doing so. But that is a topic for another day.

Contributed by Bernard Leikind, PhD.

Bernard Leikind is a physicist, and an amateur student of economics, political economy, and history. He is a current affairs junkie. He lives in Tampa, Florida, with his wife Linnea.

 Comments welcomed.

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