Money Myth 2: The government has to borrow to fund any spending that exceeds taxes collected

Fact: as with taxes, the issuance of government "debt" (e.g. the sale of Treasury Bonds) has nothing to do with funding government spending of any kind.

We've all heard the alarming statements and metaphors for our national "debt" from politicians, the media, the blogosphere, and even our friends and trusted advisers:

• "Ballooning debt"
• "Unsustainable"
• "A mountain of debt"
• "Mortgaging our future"
• "Un-payable debt"
• "Nation is bankrupt"
• "Running out of money"
• "Burden on our grandchildren"
• "Reckless spending"

Delightful phrases aren't they? So filled with hope and confidence! They are all carefully selected phrases designed to elicit anger at the "irresponsible" government along with fear in the inevitable disastrous outcomes we will face unless we take steps immediately to "cut back" and "reign in" the "bad" government's debt. 

And they are all irrelevant. 

Have you ever considered that there is something else going on here? After-all, World War II left our nation similarly "burdened" with "unsustainable" "mountains" of "debt", but were we, their descendants, burdened by it? Not at all! In fact it was that "debt" that finally ended the Great Depression and finally restored the nation's economy to full employment and growth. Maybe, just maybe, things aren't what they seem and we are seeing the world from upside-down. 

Indeed, we are once again suffering from a false paradigm left over from our gold standard days. Far too many of our good citizens are resigned to a fate that is a fiction of our overexcited imaginations, supported by a steady diet of negative metaphors to reinforce our worst fears.

So let's just take a deep breath and step back and look at what's actually going on to see if there is any basis to the debt & deficit hysteria.

• What exactly is this thing we have come to call the "National Debt"?
• What does it mean for a currency-issuing nation to "borrow" in the first place? 
• Is "debt" even the right word to describe it? Couldn't it just as equally be called National Savings since the bonds are basically interest-earning savings accounts?
• Why do we as a nation issue Treasury Bonds at all when we can just issue money?

Why issue bonds?

Let's remember that ever since we left the gold standard and moved to a floating exchange rate, we now issue our own national currency without threat of anyone seeking to force us to convert it into gold or some other currency that we don't control or create. This changes everything. Unfortunately, our economics textbooks never got updated and our politicians never got the memo!

Under the gold standard, one way for nations to issue more currency safely without it threatening their reserve supply of gold was to offer long term bonds. As long as the money issued was tied up in long terms bonds, people couldn't demand that it be exchanged for gold. The reserves were safe. Under that system, the market rate for interest on those bonds would vary based on how investors saw the ability of the nation to pay back those bonds, given that there was always a threat of exchange into gold instead when the bonds reached full term. Thirty year bonds were a great way of pushing this risk out a long time, giving the issuing nation more time. 

But after the link to gold was broken, what is the threat? There is none. New bonds are simply issued to replace the old ones. Who can demand of our nation that we pay high interest rates? No one. We control the amount we offer to investors of our bonds, at least in the short term. And what is the purpose of issuing thirty year bonds? We really have no use for them. We could issue no bonds and just pay an overnight interest rate if we wanted to. Or we could offer only short term 3 month bonds. There are reasons to keep issuing bonds since they are used by savers and pension funds and financial institutions and trading partners as the safest of all investments. They provide a steady flow of interest income. 

Fine. But we can never be threatened with our own national money. Bond vigilantes hold no power over us. We pay what we want to those who save our money.

Is it really "debt"?

Can a government borrow its own IOUs? It doesn't make any sense when you think about it, does it. If the government is the sole issuer of our national currency, how can it possibly need to borrow it first from the public before it can spend? The public only obtains the government money when it is spend into the economy. 

Okay, so does the government have to borrow some of it back in order to spend it again? Well that makes no sense either: the government can just issue more if it needs to spend. So if it doesn't need money to spend, and if it makes no sense to borrow its own IOUs (money), what are bond sales all about?

Here I must apologize: this has to get just a little technical. The reason is that bond sales are used by the Fed to manage the interest rate between banks. Seriously, that's the main reason - it has nothing to do with raising money for government spending! 

Here's how it works:

When the government spends or invests it simply credits the bank accounts of businesses (e.g. Boeing to buy a jet or a construction company to build a bridge) and consumers (e.g. a soldier, judge, or Social Security recipient). In doing so it is injecting new money into the economy (the process later works in reverse when we pay taxes, removing some of that government money back out of the economy). When this happens, the bank receiving the funds must have its account at the Central Bank marked up to reflect the increase. We call this "reserves" but it is basically our banks' checking accounts and the Central Bank. 

Now across the whole economy, this increase in bank reserves creates an excess. Banks lend each other reserves to meet their regulatory requirements at an overnight interest rate that the Central Bank sets (the Fed Funds Rate in the US). When the government spends, it adds more reserves into the system than the banks need, and so the interest rate has a tendency to drop to zero. So now in order for the Fed to hit its target rate, it must remove some of these excess reserves. 

How? You guessed it - it sells government bonds! 

Government bond sales are basically a way for the Fed to drain excess reserves from the banking system in order to keep the interest rate at its target rate. We can debate whether it even needs an overnight target rate, but for now let's just stick with the basics. Bond sales don't fund government spending, they simply help the Fed manage interest rates, which it believes helps it to regulate the economy.

Can we ever run out of buyers of our bonds? No, not really. Bond sales always follow spending, and so the excess reserves in the banking system are always there which must be converted into bonds. The major banks that participate as brokers for these bonds will always buy them. Even if there were no buyers, the Fed can always "buy" the bonds itself which is basically the same thing as if the government simply spent money and didn't issue bonds at all. 

There is no sovereign "debt" crisis. What we call the "National Debt" really isn't debt at all. Debt in every real sense is something you owe that you repay from your earnings over time. Sovereign governments don;t have "income" (they just collect back their own IOUs), and they are never in "debt" for the IOUs only they can issue. It's the wrong term for what's going on. 

Should we just call it our national savings? 

There are two sides to every balance sheet entry, right? When a bank makes a loan, the bank has an asset (your loan) and a liability (the money it puts in your account that you borrowed). You have an asset (the money in your account) and the liability (the obligation to pay back the bank).

It's the same with government money. The other side of the liability that we love to call "national debt" is trillions of dollars of assets in the form of private sector savings! When we talk about rising "national debt" we are talking about rising non-government savings, and similarly if our politicians want to reduce the debt, they are also saying they want to remove savings from the economy. You can't take one without the other.

The accumulation of government money in the economy that ends up in the form of government bonds is nothing more than a record of the net currency savings of the economy. It is the amount of money the government has invested into the economy to help the economy, the nation, and the people. Can we do a better job of allocating where this money goes? Absolutely. But is it a problem that it exists? No! Will the number grow? Yes, as long as our economy keep expanding, our population keeps growing, and we keep seeking to save more and more, there will be greater and greater accumulations of money help by non-government entities. 

It's not debt. It's not to be feared. It doesn't threaten our future or prevent us from doing more in the present to help people or the economy. 

And that's great news! Spread the word!

More reading

You don't have to take my word for it. Frank Newman is a former Deputy Secretary of the Treasury who has been trying to get the word out that we simply do not have a national debt problem - see here. Read his book Freedom from National Debt. We have just been applying the wrong terminology and framework to the way our sovereign currency works. 

(Note: in the US, we have set an arbitrary rule that the Treasury needs to maintain a certain balance in its account at the Fed. So at the end of each day, the Treasury makes sure that balance is kept. However, this is not a "funding" mechanism. See here).