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

"The Seven Deadly Innocent Frauds of Economic Policy" by Warren Mosler

“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.