There are few things as confusing as the concept of money. Thorough explanations quickly become bogged down in technical weeds. I am going to attempt to make this as simple as possible for the general reader. It will probably upset my more technically savvy financial friends, but let the chips fall where they may.
Perhaps the most fundamental concept in finance is the reality that the money you take in must equal the money you spend over some reasonable period. This applies to individuals, companies, and countries, although many believe that governments are somehow immune and can just spend and spend.
The real world of Finance Is made exceptionally complicated by the interaction of the Treasury, the Federal Reserve, and the banking system, as well as the relationship between cash money, bank deposits, digital currency, liabilities, inter-governmental agency transfers, and temporary overnight transactions.
Let’s simplify things by assuming the economy operates 100% in cash, the kind we carry in our wallets. When anyone buys something, they pay cash for it. (For practical reasons, that is not done, but it is theoretically possible, and it helps simplify the explanation of what is going on.) The seller takes the cash and either spend it or invests it. We all know that if an individual, a family, or a business habitually spends more than it earns, they will eventually go bankrupt. Somehow, that does not seem to apply to the Government although there are innumerable examples of sovereign defaults.
Most people are aware that the Government habitually spends a great deal more than it collects in taxes. How is this possible, year after year?
In the private sector, when you want to spend more than you earn, you can borrow, up to a point where no one will lend you any more money. The Government operates the same way, except that there seems to be no real limit to its borrowing. (The periodic “debt ceiling crisis” is political fiction, and everyone knows it, despite the automatic media frenzy.)
In my simplified all-cash world, taxpayers send taxes to the IRS which turns the money over to the Treasury to spend, based on what Congress has authorized. Inevitably, there is a shortfall, because the Treasury does not have enough cash to cover all the salaries, supplies, welfare, etc. that the Government is committed to paying. So, the Treasury borrows the deficit.
Stay with me now, because you have to pay attention in order to follow which walnut shell the pea is hiding under.
The Fed is an independent arm of the Government, but essentially it is a huge bank that finances the Treasury’s borrowing. In normal private banking, the lending bank provides money (in the form of credit) to the borrower and takes debt (bonds) in return. Since the Fed is not sitting on a pile of cash like a commercial bank, it simply creates the money out of thin air by allowing the Treasury to print what it needs. The Fed adds the Treasury’s new debt to the bank’s assets (known as “expanding its balance sheet”).
Unlike commercial banking, the Fed does not keep its books in balance by reducing its cash account, because it has not given any cash to the Treasury. (It just gives it a credit.) The Treasury’s balance sheet looks to be in balance because it adds the cash it has printed to its assets, but shows the debt it owes to the Fed as a liability (i.e., it increases the nation’s debt).
It should be noted that regular commercial banks also engage in creating money out of thin air by lending money it does not have on hand. However, the amount of “leverage” they are permitted to have in their balance sheet is strictly limited by law. In addition, banks expand credit on real production so the expansion of money is linked to the expansion of goods and services. Banks also are examined regularly by government officials, are accountable to shareholders, and must comply with a host of securities laws and accounting practices. There really is no one supervising the FED or the Treasury in the same sense as money creators in the private sector. When it comes to government “banking”, the question is always who supervises the supervisors.
What supervision there is most often performed by politicians who are not particularly knowledgeable and who often have a vested interest in the money expansion pursued by the FED, which finances the spending goals of the same politicians. It is not a system that leads to much if any control.
“Leverage” is a financial term that refers to the relationship between one’s assets and one’s net worth. For example, if you have a house worth $500,000 and a mortgage of $400,000, your equity is only $100,000, and your leverage is 5 to 1. The more leverage you have, the more risk you are placing on your net worth since a small change in the value of your assets has a disproportionate effect on your equity (net worth). As leverage increases, lenders perceive that they are taking greater risks by lending more money to that borrower, with the result that they either refuse to lend more or only do so if they realize a higher interest rate return to compensate for the greater risk being assumed. Often this starts a negative feedback loop where higher risk leads to higher interest rates, which increases the risk of being unable to service the debt, which leads to still higher interest rates…..
The Treasury does not finance all of its deficit spending in this manner. It sells some portion of its new debt to the public or to foreign investors. However, it also engages in another activity that is a serious source of concern. It borrows from the huge Social Security Trust Funds. This is essentially the left-hand borrowing from the right-hand, much like a family borrowing from a child’s college education account to pay this month’s rent.
Since it began 90 years ago the Social Security System has collected far more in taxes than it has paid out in benefits, since only a small percentage of the population was retired until recently. If it operated like a proper insurance company, it would invest annual excess receipts in a diversified portfolio of assets. Instead, it only invests in U.S. Government debt. There are a number of reasons for this, mostly political, but in essence, it is investing in what amounts to Government promises to pay. The Government actually spends the cash Social Security collects in taxes, and in return gets Government bonds. Benefits are not funded primarily from accumulated reserves, but increasingly from current cash collections. This, of course, would make it a classical Ponzi scheme, except for the fact that the public trusts the Government’s promises.
Any lender has to ask whether they will get all the money they are owed. The more debt the Government owes, the greater the chance of default, although in the case of the U.S., there is little chance of actually not honoring its debts, notwithstanding periodic grandstanding threats in Congress.
The problem is that the appetite for lending money to the U.S. Government is shrinking as the borrowed funds are used for consumption (e.g., welfare) instead of activities that will lead to increased Government revenues. Interest rates have to be substantially increased in order to attract lenders.
What happens when investors are insufficient to cover the amounts the Treasury needs to borrow, and when Social Security funds are no longer a cheap source of Government financing? The answer is simple. Someone has to be screwed. Either taxes have to be raised or benefits reduced, both politically lethal choices for politicians. The only other choice is to reduce the real value of bond obligations via higher inflation, which screws both investors and the public but can be conveniently blamed on “the other party” (i.e., the one not in power). Since the true causes of inflation can be finessed due to the public’s ignorance, political costs may be deflected for a while.
A glib answer is given by those who argue that the Government can always just print more money, or that a new form of “money” like cryptocurrency will come along to save us. Those are just examples of management by hope, and they are usually proposed by those who either don’t understand how money works or whose personal interests are better served by keeping the public ignorant and confused. The politically popular strategy of alleviating the ravages of inflation by handing out “free” Government money is a cruel way of buying off the anger of the masses in the short term but with negative long-term consequences.
Let’s pause and see where we are in our example
- The Government meets its immediate cash needs.
- The economy has benefited in the short term from the stimulus resulting from the excess Government spending.
- The Fed has increased its leverage, causing investors to worry about the U.S.’ financial stability. Interest rates rise accordingly.
- Investors who bought the bonds lose value as interest rates rise. (A bond paying 3% interest is worth less when interest rates rise above 3%.)
- Taxpayers enjoy a currently booming economy but at the cost of higher future taxes being required.
- The solvency of the Social Security System is further imperiled by its already dangerous condition.
As my friend Art Klee once put it, “We are like people trapped on an iceberg in polar regions, floating toward the Equator, but enjoying the sun.”
As we move through 2023 and into the next election cycle, The Prickly Pear will resume Take Action recommendations and information.