Friday, February 3, 2012

The False Household Analogy

Periodically, we see the idea surface that the federal government’s budget should be compared to a household budget. We see what the debt is compared to yearly income.  We see how much the debt payments are, how much spending might be eliminated, etc.
Then people freak out.  And that makes sense. We have a large public debt, and we are spending more money than we take in. If the federal government’s finances are like those of a household, then we are in deep doo doo.  
But luckily, these are two completely different animals.   There are many differences, but I am presenting just a few here that show some of the substantive contrasts between the federal budget and a household budget.  Before we start, please remember that we are talking about the federal budget here.  State and local governments are a different matter. The analogy to a household in that context is certainly less wrong.
I have tried to be brief.  There are many extensions of each of these points that can be discussed, but I erased a lot of that in an effort to be clear and succinct......somewhat!  I hope that the points are clear.  Hopefully readers will point out any murky spots to me.
ONE:  Perhaps the main budgetary difference between a household and the federal government is this:  A household is a user of currency.  The federal government is an issuer of currency.
This means that a household needs an income in order to spend.  It must get money from somewhere else. The federal government does not, simply because it is the creator of the money to begin with!  
When the government spends money, it creates dollars out of nothing. This introduces currency into the economy.  So why does the government tax if it does not actually need taxes for the sake of revenue?  One reason is that taxation helps establish a currency.  If taxes are required in dollars, then people must obtain dollars through economic transactions.   Taxation insures that people will use dollars.
But the more important reason for our purpose here is this: The government taxes to reduce the amount of dollars in existence.  This offsets the dollars created by government spending in order to prevent inflation.  If government spending creates dollars, then taxation destroys dollars. 
Sure, people SAY that the federal government needs to tax in order to spend, but we also say that the sun rises and sets.  It is a helpful, shorthand way of talking about it.  But operationally, the most accurate way to describe government spending and taxation is to say that the government creates money out of nothing when it spends, and it destroys money into nothing when it taxes.
So federal spending must predate federal taxation, or else there would be no money in existence to tax.  Therefore the government does not need an income to spend.
Here is another way to put it:  A household must have money coming in before it can spend.  A government must spend before it can have money coming in!
So why does the government sell bonds?   I don’t want to stray too far off topic here, so I’ll just say that it sells bonds to “soak up” extra dollars in a similar way to taxation.  And the Federal Reserve buys and sells those bonds as a way to control interest rates, but that is another subject.
TWO - A household must pay its debts off or have them retired at some point.  The federal government does not.
I must pay my debts or my ability to borrow will be compromised.  I may even face legal action if I do not pay back my debts.  When I die, my debts will be paid out of my estate or retired if there is not enough money.
However, the federal government does not ever have to settle its debt. When bonds mature they are rolled over into other bonds. 
So is a more-or-less permanent public debt sustainable?   First of all, without the public debt there would be no dollars owned free and clear (often referred to as “net financial assets”) in the economy.  Without public debt, every dollar in existence would either be from a loan, and therefore owed back to a bank, or owed to the government in taxes.  Even if I had money that I owned free and clear, elsewhere in the economy someone else would owe the corresponding debt.  So in terms of the aggregate, of the whole dollar-based economy, there would not be any net financial assets.  One person’s money would be another person’s debt.
Another way to think of it is this:  The government debt equals the savings of the non-government sector.  For any net financial assets to exist, in the form of cash, bank reserves or bonds, the government must have a public debt.

We have run a public debt since 1837, and it has been added to almost constantly since then, so I suppose that is evidence of a fairly sustainable system.
THREE - The federal government does not borrow money in the same way a household does.
This is a continuation of the same idea, but I thought it would be good to explore it further.  When a household borrows money, it does so from another institution - a bank, credit union, etc. The US does not borrow from any institution.  Rather it creates money when it needs to spend.
But wait - everyone says that China loans us money, right?  It is true that China owns US bonds, but they do not lend us money like a bank would lend a household money. 
I repeat, the US does not really borrow from China, at least not in the way we think of a household borrowing.  How could it?  China has zero capability of making dollars.  China has decided to own dollars.  They sell us products and instead of spending the dollars they make on US products, they simply prefer to save those dollars for their own reasons.  Then, instead of sitting on cash, they invest in bonds.  That way, they make interest on their savings.
And if they wanted to convert those bonds to dollars, they are free to do so at any time.  Boom.  Debt to China paid off.
Here is a concrete example of how public debt is different that private debt. Let’s think back to World War II when the government’s debt, as compared to the gross domestic product (often referred to as “GDP”), was bigger than it is now.  Did the government pay back that debt?
When was the last time you thought, “Boy, it’s tough paying off all this debt we accrued during WWII”  or  “As soon as we get all these tanks and planes paid off, we can really start living it up!”?
Public debt does not work that way. It is not borrowing money from an outside institution.  It is the creation of net financial assets into the economy. 
FOUR:  It’s great for a household to run a surplus.  It’s not necessarily great for the federal government to do so.
If I have a surplus at my house, it means I brought in more money than I spent.  I can save the remainder, which is great!
However, when the federal government runs a surplus, it means it is taxing more money out of the private sector than it is spending into it.   It is destroying more money through taxes than it is creating through spending.
A public surplus is a private deficit. 
There have been seven relatively short periods of surplus since the current public debt began accumulating in 1837.   Every single period of surplus has been closely followed by a depression or recession.   This is not a coincidence.  Destroying money out of the economy, by taxing more than spending, is counter-stimulative.
This does not mean it should never be done.  Raising taxes could be a great way to cool off the economy if excessive inflation arises.   This is because taxation destroys demand and inflation is caused by demand outstripping our ability to create products.
But surpluses are certainly counter-stimulative.
So there are a few thoughts on how the federal government’s budget is different from a household's.  It is potentially dangerous to compare the two, as it can lead us to make decisions that will hurt our economy in the name of helping it. 

A well-meaning person may think we need to run a surplus to help the economy, but it might actually damage the economy.  A well-meaning person might worry about how we are going to pay back China, but we must ask ourselves what that even means when the government needs no income to spend.  A well-meaning person may worry that the federal government will go bankrupt, but the government spends at will with money created out of nothing.  It can never be forced into bankruptcy, because it controls the unit of currency in which all its “debts” are based.
Everything stated here is true (unless I have made mistakes) whether you believe in a bigger or smaller government than what we have in place now.  There are great debates to be had about what the proper level of balance is between the public and private sector.  But these are political arguments, and while they have bearing on economics, most of the economic arguments put forward these days are wrong, and are used (wittingly or not) to try to legitimize political arguments.
I owe a lot to the following sources (another debt that doesn’t need to be paid back, I hope?):
New Economic Perspectives - a blog by several ecomomics professors at the University of Missouri at Kansas City
“In Defense of Deficits” by James K. Galbraith

Also thanks to friends Burk Braun for his writing and references, and Eric Reitan for suggesting I write a little bit about this issue.


  1. That is great, Steven, thanks for the hat-tip.

    "Sure, people SAY that the federal government needs to tax in order to spend, ..."

    I know you were trying to be brief, so I'll add that taxation has the additional purpose of making room in the economy for the government to command real resources. If the private economy is going full blast, everyone is employed and all goods are being bought, then the government would be introducing inflation by issuing still more money to buy the odd aircraft carrier it thinks it wants. It takes a cut from everyone's income so that, at the steady state, after it has issued all the money required for all the goods & jobs the economy can make, it can still buy what it needs, taking candy away from the mouths of babes to spend on paper clips, etc., as it were, without inflation.

    Of course in times of depression, with people out of work and insufficient demand, it works the other way, which is why deficit spending, lowering taxes, and pumping some extra government demand into the system has been so helpful recently. (And why austerity in Europe has been unhelpful.. this is classic Keynes.)

  2. Steven, excellent. I'm reposting this on facebook.
    Burk... I want an aircraft carrier, how much do you think one costs?

  3. I'll mention (for the record) that I saw a bumper sticker recently that read "I live within my means, why can't President Obama?" or something to that end. My immediate response (fortunately for me, kept to myself by the nature of interstate driving) was "because you're not trying to take care of 150 million people."

  4. Burk,

    I think your point is the flip-side of the idea that the government taxes to prevent inflation. Absolutely.

    Thanks, Kelly!

    Yeah, if people understood these issues better, they would realize that by allowing such prolonged unemployment, we are living far beneath our means! We could be producing a lot more (scientific research, for one?)

  5. This article is deeply and profoundly incorrect. Money is indeed created and destroyed constantly, however this is done by private banks, and (somewhat) controlled by the private federal reserve.

  6. Hi Vadim,

    Money is certainly created by banks. But it is owed back. Therefore, the existing asset, created by the bank, has a corresponding liability That's why it is important to distinguish between money and net financial assets (money in the non-government sector that is not owed back).

  7. Indeed the money created by banks has associated assets; but if the loan is not repaid the money does not disappear. But this is largely irrelevant to my critique of this article.

    My point is that it is NOT the government that creates and destroys money. Much like any private citizen or non-bank entity (although much larger) it solicits and repays money from the private world. The private world has a great deal of faith in the U.S. government at present to make future payments (if necessary, by seizing private assets via taxes). However there is a critical balance between the government's debt load and this faith.

  8. Hi, Vadim-

    I am not sure what the problem is. The government certainly does have the power to create money. The Fed presses a few keys, and suddenly the banks have $2 trillion in reserves. Or the Treasury issues a trillion dollars in bonds, which the government spends, and voila, more (effective) money. This is just like the banks issuing loans (making money), which are later extinguished by repayment.

    These are parallel systems, and in good times, banks do certainly take the lead. But during the current crisis, bank lending ground to a halt, and indeed went into reverse via deleveraging. That is why deficit spending by the government has been so important, if insufficient.

    The practice of government borrowing (issuing bonds) to match its excess spending is neither economically significant (savings will still be savings, whether invested in bonds or elsewhere; the inflation impact is minimal at best) nor necessary.. the spending could take place either way, as Steven notes.

    Both stories about money creation are true, and their relative importance varies over time. But in the end, the banks are subordinate to the government, which sets/creates the legal tender and validates it through its taxation, spending, borrowing, and regulatory practices. You might study the career of Alexander Hamilton on this score.

  9. 1. The Fed is a private organization, beholden primarily to private banks and not to the federal government or American citizens.
    2. Federal bonds do not create money, they loan money to the government when they are bought. If faith in the government falls, nobody will buy the bonds, and this avenue of revenue generation will vanish.

    The central thesis of the original blog article is that the federal government creates the money. Based on this thesis various conclusions are drawn, e.g. federal spending is beneficial, deficits are useful. This central thesis is incorrect, and therefore all the conclusions drawn therefrom are unjustified at best.

  10. Actually, the Fed is not a completely private institution, and is subject to Congressional oversight. And the Fed doesn't create money, nor "loan" it to the government. The Treasury Dept. creates money, which it sells to the Fed.

  11. Suppose for a moment that the government spent money without issuing bonds. Your scenario would then fall apart. But that would be easily done- the only impediment is an archaic legal system. More importantly, the Fed may be partly run by the banks, but it is far from a private institution. "The Federal Reserve System is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system." ... "The Board of Governors of the Federal Reserve System is a federal government agency."

    Additionally, banks themselves are partly government run- they are much more extensively regulated than other businesses, for very good reasons, if partially forgotten. They are somewhat like lawyers being officers of the court.

    At any rate, given the current system, where banks and the government can each create money by issuing matching credit/liabilities/assets, what is the role of each, and are government deficits useful? The overall three-way monetary balance of private spending/saving, export deficit/surplus, and government surplus/deficit is an accounting balance, (summing to zero), and if two sides of this balance (export deficits and private saving) are negative, then the only thing preventing economic implosion is a sustained government deficit, whether printed outright, or borrowed from private or foreign savers who pile up assets.

  12. Vadim,

    There is a lot of confusion about bonds - because it is confusing!

    First the federal government spends. It must logically spend before it can tax or sell bonds - if the only money in existence was created by bank loans, then can you imagine the "money-suck" on the non-government sector taxation would cause? There would be a giant net financial hole owed to banks.

    Then the Treasury issues a bond. The non-government sector buys the bond. So the government spends $10 into the economy, then takes out $10 in the form of a bond sale. But here is where the meat of the issue is.....$10 in, $10 out, but the bond remains!

    And a bond is very liquid. It can be sold at anytime or borrowed against. The Fed has a huge amount of bonds on its books - which means the corresponding cash or bank reserves are in the private sector, owned free and clear.

    So the government spends, then the private sector holds those assets in the form of cash, bank reserves or bonds.

  13. Steven-

    I think there an alternate story that is at issue. While fiat currencies may be set up from scratch by governments, they are often taken over from pre-existing currencies. To take the Austrian's position, gold is perhaps the paradigmatic natural currency. So is the "note of hand", i.e. the personal IOU, often seen in Victorian novels. Prior to the organized state, people dealt with each other through such spontaneous/natural currencies.

    I think we (you and I) take it as given that there is a virtue to the state taking over this kind of currency, enforcing uniformity of minting, value, weight, etc. And we also take it as a virtue that the state transforms the currency from some kind of commodity base to a pure fiat (paper/electronic) base which, while obviously prone to government failure, is also much more manageable and amenable to macro-economic management (insofar as one recognizes such management being needed!).

    All this drives the Ron Paul-ists completely nuts, since they look at all this through the prism of state failures... Weimar(!), Zimbabwe(!). That is part and parcel of distrusting and denigrating the state in general. Our own state had a slight failure in the inflationary 70's, but on the whole, the record is rather good.

    Of course if the nuts gain control and conduct circuses like repudiating the debt and the like, then their prophecy of bad monetary management will be self-fulfilling.

  14. Burk,

    Great points. I posted this on Reddit and some of the criticisms there are along those lines. I never really linked Ron Paul's gold standard fixation with his distrust of the public sphere, but of course, I should have. When he is talking about our dollar losing value, I always associated it with some sort of patriotic bravado about the stature of our currency in the world, but actually it makes much more sense that he just wants to limit the abilities of the government.

    Considering the war in Iraq, he may have a point. But I wouldn't want us to avoid war because of monetary policy. We should avoid it be considering the costs in real resources, not to mention the moral considerations!

    But we do have a regulated, uniform, government-issued currency, and even if it arose out of trading gold, it makes little difference.

    If people exchanged their gold for printed dollars in the past, then the government was, in effect, buying the gold from the citizens with money printed from nothing, thus introducing the currency (in its modern form). So even under the gold standard, it is paper money, set up to be exchanged at whatever rate the government agrees to, thus limiting its fiscal/monetary abilities. But the idea of paper money, created from nothing, remains.

    Am I thinking right on this?

  15. Great post, Steve.

    Nuclear: I think you can make the point more strongly. The Fed is not remotely private. Show me a private firm whose board of directors is nominated by the President and subject to Senate confirmation. Show me a private firm that is required to turn over ALL of its net profits to the Treasury. Show me (I can go on and on).

    But the Fed does most certainly create money. Economists have many different measures of the US money supply (M0, M1, M2, etc.) M0 is the monetary base. What we call high-powered money. It consists of bank reserves and currency in circulation. Yes, the Treasury mints currency, but the Fed creates every dollar of reserves, and they do it just buy pushing buttons on a keyboard.

  16. Thanks for the comment! Your blog is a phenomenal resource for interested amateurs like myself.

  17. Hi, Steven-

    I think strictly, speaking, a properly conducted gold standard system would not be equivalent to a fiat system, because the government would be perpetually obliged to redeem anyone's gold for some realistic amount of the paper currency. In such a system, the government would be barred from setting the gold price arbitrarily, rather using some kind of market system to price the commodity base (gold).

    I don't really know how feasible such a system would be, since the government basically buys up all the gold and stores in Fort Knox, so coming up with a real-world price for gold becomes an exercise untethered from reality, somewhat like the CDOs, swaps, and other instruments seen lately. The government corners the market in gold, (at least in practice, if not in law), and can sell off/buy up stock to manipulate its price. This temptation leads to the goverment fixing the price, and eventually to complete fiat status with no gold backing at all.

    However, in a gold-backed system, large swings can still take place due to events like large influxes of mined gold, or sustained negative balance of payments issues during the depression; the base of gold may be drained away, and becomes very important. Countries were forced to devalue domestically due to losing their underlying gold stocks, which was disastrous, and had happened repeatedly during the 1800's when countries were on gold (US) or silver, or both. This led to the long debates about bimetalism, silver vs gold, the Wizard of OZ, etc.

  18. Kansas City - my apologies. I suppose I should be more clear what I mean when I say "create" in terms of money. What I meant was that the Treasury mints, that is to say physically creates, money. The Fed certainly creates money in the sense that it changes what funds are in circulation - electronic money is, in the end, just as real as physical currency!

  19. Burk,

    Absolutely, thanks for the description. I love the motivation behind The Wizard of Oz! And I haven't thought of the government acting to manipulate gold, but that makes sense. Obviously, they can always just change the exchange rate as well, move to different metals, etc. And any time the government really needs to spend a lot quickly, like in war time, they tend to abandon it.

    I suppose my late-night, unclear post last night meant to suggest that even gold standard money is still debt, ontologically speaking. Because the bills, even backed by gold, are still used to purchase gold or at least to represent it, even in some round-about way. They are still IOU's.

  20. A dollar is the promise to re-pay a debt backed by the taxing authority of the underlying government. What can we say about that promise to pay given the nominal value of a dollar today vs. a dollar at any point in past history? Does this matter?