Why Congress Should NOT Increase the Government’s Debt Limit
Ready for a little monetary demystification? L. Randall Wray explains how the anti-deficit maniacs are simply promoting myths — from the ‘risk’ of government insolvency to the fretting about Chinese holdings of Treasures.
In a piece written for CNN, Senator Evan Bayh rails against the growing federal government budget deficit. He warns that next month the Treasury will ask Congress to raise the debt limit from its current $12.1 trillion, and promises that he will vote “no.” It is time, he argues, for Congress to stand up for our nation’s future by creating a bi-partisan debt commission that would finally put an end to “unsustainable” deficit spending.
The Senator goes on:
When President George W. Bush took office in 2001, our public debt amounted to 33 percent of our economy. Today, it is 60 percent of our gross domestic product. If we do nothing, our debt is projected to swell to over 70 percent by 2019. To put those numbers in perspective: If you divided the debt equally among all Americans, every man, woman and child living in the United States today would owe more than $39,000.
I presume the Senator has got his math correct, but there is a glaring error in his English that can be corrected by substituting an “n” for an “e”: If you divided the debt equally among all Americans, every man, woman and child living in the United States today would own more than $39,000. Government debt is a private asset. You and I do not owe government debt, we own it. Indeed, the only source of net dollar-denominated financial wealth is federal government debt.
The national, sovereign government spends by crediting the bank accounts of a recipient, or by cutting a check that the recipient deposits in her bank account. In both cases, the bank’s reserves are credited. If the recipient decides she would rather have cash, the bank provides this on demand, and the government debits the bank’s reserves. Tax payments reverse the procedure: the government debits the taxpayer’s account and her bank’s reserves. If the government spends more than it taxes, this results in net credits to bank accounts. This is what we call a budget deficit, and reserves plus cash outstanding increase by the same amount
Reserves and cash are liabilities of the government (in the U.S. reserves and paper money are liabilities of the Fed; coins are liabilities of the Treasury). What backs up these government liabilities? Another way of putting it is: For what is the government liable? As Edward Harrison notes, some nations issue currencies that refer to legal tender laws (as does the U.S. Federal Reserve note). Paper currency issued in the UK is more forthright: the Queen promises to redeem a ten pound note by proffering ten pounds. In other words, by taking currency to the Treasury, it can be redeemed for more Treasury currency.
There is, however, a more important promise. The Treasury will allow you to “redeem” government liabilities for your own liabilities to the government. In other words, you can pay taxes by delivering the government’s own IOUs to the Treasury. In practice, you write a check to your bank, and the bank makes the payment for you using its reserves (a liability of the Fed). So, to put it as concisely as possible: government spends by crediting bank accounts and taxes by debiting them; government spending takes the form of emitting IOUs while taxes take the form of eliminating those IOUs.
There is one other type of government liability: interest-earning treasury bills (short term) and bonds (longer maturity). These are government IOUs that pay interest. An individual or a bank can buy these through “redemption” of currency or reserves. Hence, government sales of bills and bonds are really just a substitution of one kind of government liability (bills and bonds that pay interest) for another government liability (currency that pays no interest, or reserves that now pay low interest). Government pays interest on its debt in exactly the same manner that it makes any other type of payment: by crediting bank accounts.
Note that the debt limit Senator Bayh refuses to raise applies only to Treasury bills and bonds. It does not apply to coins, Federal Reserve notes, or bank reserves. All of these are also government debt — but they are explicitly excluded from debt limits. The only real difference is that they pay either zero or low interest. Hence, while the Fed’s balance sheet has practically exploded as it tries to deal with the financial crisis, its $2 trillion debt is excluded from the debt limit. Yet, in terms of “sustainability” and risks of government insolvency, all this government debt is created equal. There is no default risk on the debt. Government can always afford to buy anything for sale by crediting bank deposits, and government can always service its debt by crediting interest to bank accounts.
The anti-deficit mania in Washington is getting crazier by the day. So here is what I propose: let’s support Senator Bayh’s proposal to “just say no” to raising the debt ceiling. Once the federal debt reaches $12.1 trillion, the Treasury would be prohibited from selling any more bonds. Treasury would continue to spend by crediting bank accounts of recipients, and reserve accounts of their banks. Banks would offer excess reserves in overnight markets, but would find no takers — so they would have to be content holding reserves and earning whatever rate the Fed wants to pay. If the budget deficit reaches $1 trillion over the coming year, banks will find themselves with another trillion dollars of reserves paying low interest. But as Chairman Bernanke told Congress, this is no problem, because the Fed spends simply by crediting bank accounts.
Currently, when the Treasury wants to spend, it transfers funds from its tax and loan accounts at private banks (to minimize effects on banking system reserves, the Treasury temporarily holds tax receipts in private banks) to its account at the Fed. If its spending exceeds the deposits it has in private banks, it first sells bills or bonds to special banks that are allowed to buy them on credit (this is, again, to minimize undesired impacts on bank reserves); the Treasury’s account at the Fed is credited by the amount of the sale. This procedure is equivalent to allowing an overdraft facility for the special banks so that they can buy Treasury debt before they have the reserves they need to redeem. When the Treasury spends, private banks are credited with reserves, cancelling the overdraft.
How would this work if we eliminate sales of Treasury bills and bonds? In effect, the Fed would offer an overdraft to the Treasury rather than to the private banks. Now the Treasury could spend without first moving deposits to the Fed. This would increase the deposit of the recipient of the Treasury’s spending and also the reserves of the recipient’s bank. Banks would earn interest on their reserves-at the rate the Fed chooses. The only change to current operating procedure is to give the Treasury the right to overdrafts-something the Fed already allows to private banks.
Voila! No more Treasury bills and bonds issued. No more debates about government debt limits. Government debt would be limited to cash plus reserves, which are excluded from such calculations. This would allow Senator Bayh and other deficit warriors to stop worrying about Treasury debt and to move on to something important like the loss of millions of jobs.
There is one other benefit to this approach. For several years, there has been much fretting about Chinese holdings of Treasuries. President Obama even paid a visit to China in an orchestrated attempt to promote friendship so that the Chinese would continue to “lend” to us so that our government can continue to run a budget deficit. This is pure unadulterated nonsense. Our government spends by crediting bank accounts — it does not borrow back its own IOUs from the Chinese in order to spend. Rather, US trade deficits with China lead to dollar-denominated deposits credited to Chinese exporters that are traded with the Bank of China for RMB reserves. The Bank of China then trades dollar reserves for US Treasuries to earn interest. If we stop issuing Treasuries, they will hold low-interest-earning dollar reserves.
The result? No more US indebtedness to China.
Roosevelt Institute Braintruster L. Randall Wray is a professor of economics and research director of the Center for Full Employment and Price Stability at the University of Missouri–Kansas City.