Wednesday, December 30, 2009

Congress gives a lesson on money creation

Last Thursday Congress voted to raise the debt ceiling. Prior to that the government was up against its "legal limit" on how much debt it could issue, but with a simple vote the government's spending power increased by $290 billion.

This should show that the only real constraint on how much the government can spend is the constraint it imposes on itself. Any amount--whether $290 billion or $2.9 trillion--is made possible by decree.

Some would argue that the vote simply gave the government the right to "borrow" $290 billion more, so it did not really increase its spending power at all, only the amount it could take from others. This argument would be wrong.

Government spending, by definition, increases the amount of reserves in the banking system and those reserves are the funds used to buy Treasury securities. Therefore, it is correct to say that government spending itself provides the money to buy the debt.

How else can you explain how the national debt went from $900 billion to $12.4 trillion over the past 30 years with interest rates falling to historic lows or even zero? If the issuance of government debt were truly "borrowing" then rates would have climbed to astronomical levels.

The reality is, interest rates are set by the central bank and that goes for long-term rates as well as short term rates. (Long term rates are influenced by what the market perceives the central bank's interest rate policy is going to be over the term of the bond, note or whatever.)

Having a self-imposed constraint it silly because it necessitates this exercise in voting on debt limit increases every couple of years. And since all money emanates from the government's own money (the monetary base) it is normal to assume that the quantity of money will grow with a growing economy (the latter being desirable), so why impose a constraint on the size of the monetary base in the first place? It's dumb...almost like being on a gold standard.

Congress should do away with the debt limit and with the rule that the Treasury is not allowed to run an overdraft in its account at the Fed and focus instead on policies that achieve full output and employment irrespective of the level of public debt securities outstanding.

1 comment:

Ryan Harris said...

"The national debt went from $900 billion to $12.4 trillion over the past 30 years with interest rates falling to historic lows" (~ 1277% increase)

According to the census figures ( The average family in America went from approx 45,000 to 50,000 of annual income over the same thirty years. (~ 10% increase )

Steady deficits, debt growth and increases in the amount of bank reserves didn't seem to cause income growth to occur at a similar pace which is odd because the majority of government outlays were for transfer payments to the public which should create demand for labor. hmm.