Recently, democrats and republicans have been arguing over how to reduce the deficit and, eventually, the national debt. They differ on exactly how this should be done and how quickly this should be done. However, they both agree that the deficit should be reduced, and that the national debt should eventually be brought down. They argue that America is going deeply into debt that we will never be able to repay and that we are in danger of bankrupting America. The problem is, however, they are all wrong. It is impossible for the US to go bankrupt, and the national debt, is in fact, not really even debt, at least not in the way individuals or businesses have debt. Not only that, but paying down the debt will cause recession.
In the last forty years, since the US left the gold standard, we have been using a monetary system never before seen in history. The current system was a necessary consequence of modern economic development. For much of prior economic history, using gold as currency was a relatively stable system because there was always more of it being discovered. The rising supply of gold was enough to cover the rise in demand for currency from the growing productivity of the industrial revolution. However, right around the time of the Great Depression, a number of factors including the slowing rise in the gold supply, as well as poor policy decisions by the newly created Federal Reserve, caused a constriction in the money supply relative to demand. In fact, many economists today accept the conclusion of the famous economist Milton Friedman that if a constricted money supply wasn’t the main cause of the Great Depression, it surely contributed to the depth and length of it. Even though temporarily leaving the gold standard was credited in part with finally lifting the world economy out of depression, we still couldn’t see past the desire to return to it. Eventually, due to war expenditures, the US was forced to finally leave the gold standard once and for all in 1971. Instead, the money supply would now be entirely regulated by government spending and by the open market operations of the central bank, the Federal Reserve (or just, the Fed). The value of the dollar would now “float” freely, determined by the free market as it bought and sold the currency in exchange for the currencies of other nations. When this happened, it also meant that the actual value of the national debt, which is denominated in dollars, also freely floats, and is determined by the free market.
Our currency is now established by government fiat. This simply means that the currency is created by decree of law. Its value lies in the trust people have that our nation will continue to exist and be able to defend itself, and its interests, militarily. Our stable system of government and our military strength are what make the dollar so trusted around the world, so much so that it has been used as the international reserve currency since WWII. As discussed in previous posts, this makes the dollar just as valuable, and just as “real”, as any other form of currency, including gold.
Instead of maintaining a set supply of money according to how much gold happens to exist in the world, we are able to adjust the supply of dollars in order to meet demand, thus maintaining price stability and a healthy economy. This is the main job given to the Federal Reserve. Its stated mission is to maintain low inflation and high employment by manipulating the money supply. It is given this power mainly to remove the political motivations that could otherwise influence policy decisions if it was handled by congress or the executive branch.
Imagine if a new country with our current system was created today, and a new currency was created called the “armchair”. The citizens of this country may hold other foreign currency, or commodities, but none of them would have any armchair, because none had been printed yet. How would the new government get armchair into the hands of its citizens? It would have spend them into existence. In a system of fiat currency with floating exchange rates, this is the only way to create new base money. Now, this is not to say that the government would be creating wealth out of nothing, rather, it is stimulating the creation of wealth by offering the new currency as payment. So, the government would print of a bunch of armchair and hand them out to citizens in exchange for goods and services to be placed into public use. Once there was enough currency in circulation, the citizens would begin to exchange it amongst themselves, and eventually everyone in the economy would be producing something and being paid for it in armchair. So, why would the citizens of the country accept armchair as payment in the first place? First, the currency is legal tender. This means that when courts enforce contract law, a debt is considered paid when an offer of the appropriate amount of legal currency is offered. A party must accept an amount of currency equal in value to whatever payment is described in the contract for it to be enforced. Also, to establish its value, the government must create a tax payable only in the currency. If you have to pay a percentage of your income to the government in its currency, then you either need to buy some of it, or be paid with it in at least the amount owed in tax. This establishes a market for the currency where people will buy and sell it. There is also a second reason a tax needs to be established. Once the economy is at full employment, the government needs to begin removing some of the currency from circulation to offset some of the new spending it does. However, it couldn’t remove all of the currency created in a given year due to the demand placed on the new currency by productivity growth. Otherwise, as we’ve seen, the economy would experience deflation. In a perfectly balanced system, the government would leave only the amount of new currency in circulation as was demanded. In our real world economy, we call the difference between the amount of currency created, and the amount of currency removed by taxes, a budget deficit. The accumulation of deficits from year to year is called the national debt. So, you can see that in any given year, it is necessary to run a deficit, and in fact grow the national debt, in order to keep the economy healthy. This is not money that ever needs to be paid back, and in fact it cannot be paid back, because if it was there wouldn’t be any currency left in existence. Likewise, if you try to pay down the national debt at a time where the demand for money is already higher than the supply (as is currently being proposed), you will create or worsen a recession because the money will simply not exist in order to spur demand. People and banks will hoard their cash and cause higher unemployment. Though the desire to pay off debt during hard times is understandable from an emotional perspective because it is rational for a person, a business, or a state to do so, it is exactly the opposite of what needs to be done at the federal level where the currency is created.
So, why does the government even issue public debt in the first place? Couldn’t we just create a surplus of new currency over what is taken out from taxes in order to meet demand without having to issue bonds to someone? Theoretically yes, however, in real world practice there are a couple of challenges to that. First, it is very difficult to measure or predict the amount of demand for currency there will be in any given year. Also, it would be difficult for the government to spend only and exactly the amount required. The government needs to be able to make some long term promises in spending, and it would not be practical for the budget to change dramatically every year completely based only on the demand for currency. So, another control on the money supply is needed. This is where the fractional reserve banking system and the central bank come into play. This will be the subject of the next post.