Money is not a Durable Good

Saving money and giving it to your children is something that can be done by an individual that benefits the individual child.  It’s not something that we as an entire nation can do collectively.  If everyone saves a hundred dollars and gives it to their descendants, it does not improve the overall society at all.  This is also true at the government level when the government can create money at will, anyways.  It doesn’t make sense for a government entity to “save” money with the intent of spending it later if it can create money at will.

There’s a lot of caveats to this, but before we get to them, I want to make sure my overall point is clear.  Let’s say you have an island of 1,000 people who use their own currency called “Isles”.  Let’s say someone came by and dropped a big ‘ol pile of Isles onto the population.  They’d all have more money, but would they be better off?  Of course not, they have more money, but no wealth was created.

Now let’s say that one year the people living on the island have a really good year and everyone has lots of food and luxuries.  Always mindful of the future, they decide to plan for years when there won’t be lots of food and luxuries.  To do this, they all decide that everyone in the village is going to put some of their Isles money into a chest, lock it, and bury it for future use.  Now let’s say 5 years later, the villagers have a lousy fishing season and must work extra hard in other areas.  Then, someone remembers the chest they saved and they all rejoice and open the chest and take out the money out and pass it around.  They’d all have more money, but are they better off’?  Of course not, they have more money, but no wealth was created.

None of the two scenarios change at all whether or not there is a government entity involved. One more look at our fictional island nation.  Let’s say that the government wants to save resources a bad fishing season.  Therefore it decides to tax more than it spends for a couple years.  During this time the economy of the island goes into recession because of the extra tax burden, and the island has less wealth and more unemployment.  Now a few years later there really is a bad fishing season.  The islanders are not even worse off than in the last scenario.  Not only does the extra money not help them, but there was already a lack of good from the recession.

The only way the scenario of a generation saving money can help, is if it gets a gluttony of foreign currency from a neighboring island.  This isn’t as easy as it sounds.  First of all, the people would have to agree to only sell goods to the neighboring island and not buy anything from it.  Second, the parent generation will have to hope that the money foreign money is still worth as much when they give it to their kids.  Third, once the kids try to spend it, they must find willing sellers on the neighboring island.  Of course, all of these things could happen, but the parent generation would have to put in a whole lot more work than the child generation would get back – if they get it back.

The point of this is that, as a society, one generation cannot make the next generation better off by saving money.  This only works on the individual or small community scale.  In fact, one generation can’t really make themselves better off by saving money.  Money is not wealth nor is it a durable good.  Some of the things we create as a country will still be around and appreciated by the next generation when they grow up.  Money, is not one of them.

 

The Purpose of Taxes

The story of taxation usually goes like this:  You earn your dollars, then give some portion of it to the government.  The government then takes your money and buys tanks, builds roads, and gives food to the poor.  For local and state governments, that is a true story.  However, for the federal government, which creates the currency, this story remains just that: A story.  Despite what most people in Washington believe, the government doesn’t need your tax dollars to fund it’s activities.  Since the federal government can create money at will, then how does it make sense to say that it needs your taxes to fund all the things that it does?  Obviously, it doesn’t.  So what is the purpose of taxation? The purpose is two-fold:  To control inflation and maintain demand for the currency.

Taxes are needed to regulate inflation.

Since you already know that government spending is constrained by inflation, not revenue, then this should make sense.  If everything else were to remain equal, then taxes would always have to rise with spending to regulate inflation.  If the government kept injecting large amounts of spending without taxation you would eventually see inflation.  However, there are several reasons that inflation and budget deficits don’t always correlate.

There are many reasons that they do not always correlate.  A high savings rate is a good example.  If people are saving dollars instead of buying items it can cause deflation.   Another is fluctuations in foreign exchange markets.  In fact, we are currently living in an age of astronomical budget deficits, and yet we are still seeing very low inflation.

The other reason for federal taxes is to maintain demand for the currency.

Once a currency has already been established, this reason isn’t as obvious.  To understand this concept you we must go back to the launch of a brand new currency.  Let’s say Ireland decided to dump the Euro and create a new currency called ‘quid’.  The Irish government would make a bunch of quid and then try to use it hire someone to sweep the streets of Dublin.  What they would find is that no one was willing to word for quids, no matter how many were offered because everyone would still be using Euros.

Ireland finds that it must artificially create a demand for quid.  They do this by declaring that all taxes must be paid in quid.  Suddenly, people need quid.  People are now willing to work for the government in exchange for quid.  They can make the quid they need to pay their taxes and then sell their excess quid to people who don’t work for the government, but must still pay their taxes in quid.  In exchange for their quid, the workers could get Euro’s(an example of a foreign exchange market) or goods and services(a plain old money transaction).  The amount of Euro’s and goods they get for their quid is negotiated by the market.  After a time the currency will take hold and the Irish government will find it can pay for anything it wants in quid.  As long as people MUST pay their taxes using quid, there will be a demand for quid.

Upon reading this I hope that you come away with a better idea of what taxes are really used for.  Most people believe that the federal government must tax people to fund itself.  When you point out that’s silly because the government can create money at will, many people will start to think you’re suggesting doing away with all taxation(which would be equally silly).  That’s why it’s important to know and to explain to others the purpose of taxes:  Regulate inflation, and maintain the currency.

We Save When the Government Spends

As you know, for you to save money, someone else must go into debt.  As i explained last time, if 300 million people save one dollar, than one person must go into debt 300 million dollars.  One person who could do this is the federal government.  So if the entire private sector wants to save money, the federal government can be the entity that goes into debt.  In fact, the total savings of the private sector cannot go up unless the federal government goes into debt.

By total savings, I mean that if you add up how many dollars everyone has and then subtract the total amount everyone owes.   Since all money is created as a debt, this will net to 0 dollars.  However, if you pull out just one entity, say the federal government’s treasury, then you can say that one entities debt must equal the others savings because eventually it all must equal zero.  That’s why federal debt equals private saving.  In fact, I understand that most economics students learn this their first year of study.  Macroeconomics 101 teaches that government deficits = private savings.  This doesn’t appear to be a secret.

A couple caveats about this.  I’ve used the term “private sector” pretty broadly here.  I’ve taken it to mean everybody except the federal government.  Most people further divide up the private sector into foreign entities and then domestic private sector.  It still doesn’t change the fact that for these groups to save money, then the federal government must run a deficit.  Again, this is something economists already know.  They learn it as a math equation:  federal income + foreign income + private domestic income = 0.

Another caveat is that this only works for total dollars in the economy.  Some people try to dispute this concept be getting other assets mixed up with money.  An example might be that someone might be in debt, but they have a house that is worth the amount of their debt.  That is a good thing because it increases their networth, but it does not increase the amount of actual money that they have.  Somebody else, like the federal government, will have to go into debt for that person’s amount of money to go up.

So what is the point of all this?  The point is that if we want the private sector to save money, we must be prepared to let the federal government run budget deficits.  It is the only way that the total savings of everyone in the country to go up.  It also means that for anyone calling on the government to balance it’s budget, they are also calling for everyone else to start spending every dollar that they make.

Think of the consequences of this:  For the federal government to have a balanced budget, and for everyone to save money for their own retirement, everyone who is young must go deeply into debt.  While a system such as this is theoretically possible in a free market, it doesn’t seem like it would be very stable.  Another consequence is that for the federal government to run a budget surplus, the private sector has to spend more money than it makes.  Think about that.  If you thought budget deficits are unsustainable, budget surpluses are even more unsustainable because the private sector has to sink into debt for them to happen.

Therefore, anyone who advocates for balancing the federal budget is also arguing for the private sector to stop saving money.  Anyone who thinks the private sector should save money, must also be for the federal government to run budget deficits if they are to remain consistent.

Anyone who advocates that the private sector needs to save money and that the federal government to balance it’s budget is arguing for two mutually exclusive goals.  And yet, this is what politicians and think tanks on both sides advocate for.  While they all have different ideas how to achieve both, I don’t think many of them realize that they are mutually exclusive goals.  Back in 1999, they were patting each other on the back for balancing the budget at the same time op eds were being written that excoriated Americans for having a negative savings rate.  Now it’s the opposite.  We’re thrilled that the private savings rate is so high, at the same time politicians are trying to figure out ways to lower the federal budget deficit.  If politicians and media know that these two goals are opposed, they sure don’t act like it.

Your Dollar Savings is Another’s Debt

The way most modern banking systems are setup, it is impossible for someone to save money without somebody else going into debt.  That’s because, as I described in a previous post, all money is created as a debt.  Therefore, for anyone to get a dollar, they must either have borrowed it, or gotten it from someone (who got it from someone who got it from someone… etc) who borrowed it.

So how does this work in practice?  Let’s say we have in our country 300 million people exactly.  Let’s also say that everyone, but one person, wants to save a dollar.  That is, they want to spend one less dollar than they make.  The only way that is possible is if the remaining person goes an extra 299,999,999 dollars in debt – 1 dollar for every other person who wants to save an extra dollar.

Think about what that means.  It means it is impossible for anyone to have more dollars than they owe, without at least one other person or entity(company, non-profit, government, etc…) owing more dollars than they have.  At first this conclusion may be hard to accept, but once you accept that all money is created as a debt you’ll realize that it has to be true.  Let’s take a look at a few more examples to better illustrate.

If you buy something from the Dollar Store, you are 1$ poorer and the Dollar store is 1$ richer.  No money was created and the Dollar store is richer at your expense.

Dollar Store +1

You – 1

Net = 0

Now let’s say you buy a 25 thousand dollar car from a dealership, but have to borrow the money from Fifth Third bank. Fifth third lends you the money so they’re now 25 thousand less dollar, but have your loan as an asset.  You have a car and a 25 thousand dollar debt.  The car dealership is now 25 thousand dollars richer.

Fifth Third – $25,000 cash

Auto Dealership + $25,000 cash

Fifth Third + $25,000 asset(your loan)

You – $25,000 debt to Fifth Third

Net = 0

As before, let’s say you buy a 25 thousand dollar car from a dealership, but have to borrow the money from Fifth Third bank. This time, however, let’s say that Fifth third doesn’t have the cash on hand and has to borrow it from the federal reserve.  This changes things a little bit, but still no one getting ahead.  Instead of being out $25,000 cash, they take on a $25,000 debt to the federal reserve.  Also, there is extra cash in the system now too.

Federal Reserve + $25,000 asset(Fifth Third Loan)

Federal Reserve – $25,000 cash (which it creates)

Fifth Third -$25,000 debt to federal reserve

Auto Dealership +25,000 cash

Fifth Third + $25,000 asset (your loan)

You – $25,000 debt to Fifth Third

Net = 0

Everything still nets to zero.  The only difference is that the federal reserve had to create 25,000 in cash to fulfill Fifth Third’s requested loan.  The federal reserve didn’t have to borrow that cash since it creates cash at will.

Now let’s take this even further.  The auto dealership isn’t just going to hang on to the cash it just received.  They’re going to take that money and put it in their own bank.  Let’s say Chase Bank.  Chase, is going to then take that money and lend it to somebody else.  Let’s say to your neighbor as a home improvement loan.  Now all that’s happened is that the auto dealership exchanges cash for an asset, and your neighbor gets cash in exchange for a debt to Chase.

Federal Reserve + $25,000 asset(Fifth Third Loan)

Federal Reserve – $25,000 cash (which it creates)

Fifth Third -$25,000 debt to federal reserve

Auto Dealership +25,000 cash (you gave them)

Fifth Third + $25,000 asset (your loan)

You – $25,000 debt to Fifth Third

Auto Dealership – $25,000 cash (deposited to Chase)

Chase + $25,000 cash (from Auto Deposit)

Chase – $25,000 debt to Auto Dealership

Auto Dealership + $25,000 asset (Bank Deposit)

Chase – $25,000 cash (loan to neighbor)

Neighbor + $25,000 cash

Chase + $25,000 asset (loan to neighbor)

Neighbor – $25,000 debt to Chase

Net = 0

I suppose I could keep going by having your neighbor go to home depot to buy supplies, but I think the point is made.  No where was cash or some other dollar asset created without a corresponding debt.  Granted, non-dollar assets (the car) changed hands, which is a good thing and is what actually makes the economy work, but the net amount of savings never changed.

One more case before I leave this topic.  Let’s look at the effect of someone defaulting on their loan.  Let’s say you default on your auto loan before even making your first payment and declare bankruptcy.  In the example where you borrowed from Fifth Third and didn’t involve the federal reserve, what would happen is that Fifth Third would lose their $25,000 asset and you would lose your $25,000 debt.  After your bankruptcy, it would look like this:

Fifth Third – $25,000 cash

Auto Dealership + $25,000 cash

Net = 0

In the case where Fifth Third had to borrow money from the federal reserve, it would look like this after your bankruptcy:

Federal Reserve + $25,000 asset(Fifth Third Loan)

Federal Reserve – $25,000 cash (which it creates)

Fifth Third -$25,000 debt to federal reserve

Auto Dealership +25,000 cash

Net = 0

Fifth Third still owes the federal reserve $25,000 dollars.  That money will have to come from more profitable loans.  So no matter what, no money was created without a debt, and nobody made any money without themselves or someone else going into debt.  As you can see from these examples and the explanations, any dollars you manage to save, must be at the expense of someone else going into debt.

The Federal Budget is Not Like Your Budget

Once upon a time, the budget of the U.S. government was just like your budget or any other household budget.  This was because at one time the government was on a gold standard.  Each dollar could be exchanged at anytime for either a small bit of gold, silver, or some combination of both.  The amount of goldsilver that you could get with a dollar would change every so often until it was changed for the last time when the United States entered the Bretton Woods system which set the value of the American dollar at 35$ per gold ounce.  Then, 27 years later, in 1971 on the Ides of August, Richard Milhouse Nixon sunk the third proverbial knife into the Gold Standard by announcing the end of gold convertibility of the U.S. dollar(West Germany and Switzerland were first and second to exit the Bretton Woods system).  The U.S. budget was no longer like a household budget.

So what do I mean when I say household budget?  A typical household or business must either earn or borrow money before it can spend it.  Everyone knows this:  You can’t spend 5$ until somebody else gives you 5$.  In other words your spending is “revenue constrained”.  When the U.S. had to convert dollars to gold, it was revenue constrained because it had a limited amount of gold.  Since 1971 the federal government no longer has to convert dollars to gold.  Combine that fact with the fact that the federal government, and only the federal government, can create dollars and you’ll realize that the federal government is no longer revenue constrained.

This last point bears repeating.  The U.S. government doesn’t have to tax or borrow money to spend it.  Most of us learn in our civic class that the government taxes it’s citizen and then spends it on roads and tanks and other items.  If the government needs more tanks or roads, it must raise taxes.  However, this is no longer the case for the federal government.  To buy the extra tanks or rail, the government can create money *poof* out of thin air to buy whatever it wants.  It could just create new money all day every day until the end of time and it would never run out or have to borrow or collect taxes.

From what I’ve seen, the first reaction most people have to this statement of fact is, “Inflation!  Inflation! Inflation! What about Inflation?” which just proves the point.  I think most people realize that the government isn’t revenue constrained because nobody ever seems to say, “That’s not true, the government can’t spend whatever it wants!  It’ll run out of dollars.”, they just object to the obvious consequence of a government spending way more than it makes in taxes: inflation.  So let’s put these these two statement of facts together.  If government spending isn’t revenue constrained, but can cause inflation when it spends a lot, then government spending is constrained by inflation, not revenue.

Why is this significant?  Because if federal spending is constrained by inflation and not tax receipts, then it completely changes when the government can “afford” something.  If inflation is low or negative, then the federal government can spend more money or cut taxes. If inflation is high, then the federal government can’t afford any more tax cuts or spending.  In fact, that means the government should spend less andor raise taxes.  These last two statements hold true no matter how high or low the current budget deficitsurplus is.  This means that if inflation is negative, the government can “afford” to cut taxes and increase spending even if it’s already in debt.  It also means that if inflation is high, the government needs to increase taxes and decrease spending even if it has a budget surplus.

As you can see, this is not like your budget at all.  Where your budget requires you to make every dollar you spend, the federal government’s budget does not require this.  The fact that government spending is constrained by inflation and not revenue is one of the central facts that Modern Money Theory is built on.

All I’ve said in this post is that government spending is constrained by inflation, not revenue.  What I did not say is that the government can  or should spend all willy-nilly without consequence.  There is a consequence and it is inflation.  What I am saying is that when congress decides if it can “afford” to do something, it shouldn’t make that determination based on what the current budget deficitsurplus is, it should make that decision based on how high inflation is.  Unfortunately, the people running our country either don’t realize this or act like they don’t realize this.

Upcoming Changes

My original intent for this blog was to fully comprehend the federal budget, how it’s created, and how the money is spent. I knew little starting, but quickly learned a lot.  However, I slowly stopped writing because I ran into a very disturbing concept called “Modern Money Theory”.  It was a  disturbing for two reasons: 1. If true it means I need to relearn how I look at modern economics and fiscal spending by the government. 2. Because I couldn’t figure out the flaw in it’s logic.  I quit writing here because I set out to prove to myself that Modern Money Theory had a major flaw.  I burrowed into economic textbooks, read about the history of U.S. money, read the writings of the federal reserve in the hopes that I would find something that would make it clear that MMT is full of crap and I don’t have to question everything I thought I knew.  I never found one.

What this means is that the subject matter of the blog is going to be changing.  I’ll still write about the U.S. budget, but I will also be writing about how the two dominate economic models are wrong and how the people following those two models are going to end up leading our country into somewhere between mediocrity and disaster.  The blog is going to involve a lot more talk on macroeconomic models and appropriate policies based on these models.  I hope to encourage a lot of civil and informed debate in the hopes that either I’m eventually proven wrong, or I change the mind of the rest of the world.  I’ll soon be writing more, but for now here’s a small, incomplete intro to Modern Money Theory:

Modern Money Theory is probably one of the worst named concepts since the “Healthy Forests Act“.  The reason is because it’s neither modern, nor a theory, and is only tangentially about money.

Modern Money Theory or MMT isn’t a theory.  It is a recognition of an unassailable fact.  The U.S. federal government (along with most sovereign nations) does not need to collect taxes before it spends money.  When it comes to taxing and spending by the federal government most people believe it works the way their high school civics teacher explained it to them: that the government levies a tax and then uses that tax money for roads, guns, schools, etc…  However, this is not the case.  The federal government, and only the federal government, can create money.  Most people refer to this as “printing money” even though, in today’s world it’s more like numbers in a computer database.  If congress wanted to, they could create 8 trillion dollars.  They don’t of course.  Instead they delegated money creation to the federal reserve.  They did this for good reason, but we’ll come back to that.  The important thing to understand is that congress is never constrained by tax revenue.

Modern Money Theory isn’t a new or “modern” concept.  It has it’s intellectual roots in chartalism which has been around for nearly a 100 years.  It predates both keynesian economics, and monetarist economics.  The concept is not incompatible with any of the mentioned economic theories for the simple reason that MMT isn’t a theory, it’s an unassailable fact.

Modern Money Theory isn’t about money, so much as it is about fiscal policy in a floating, fiat money system.  Put it all together and it should be called Your Great Granddad’s Fiscal Facts.  Oh well, too late to rename it, I suppose.

While the idea of MMT isn’t as popular as Keynesian or monetarist economics, it is not one subscribed to by only complete crackpots either.  It is embraced by modern economic professors, financiers, and even ore or two well-known economists.  It is also not confined to American economists.  The concept has grown enough that Paul Krugman felt it necessary to try and use his New York times column to disprove it(as you may have guessed, he didn’t make a convincing argument).

What’s going to follow in my next posts are my views on several economic concepts.  Some will go against the mainstream(like trade deficits and national debt) and others will be mundane(like inflation and deflation).