You Shouldn’t Be Scared of the Federal Deficit
Photo by Matthias Groeneveld from Pexels
One of the things we count on is politicians always worrying about the Federal Deficit, which they oftentimes call the National Debt. For clarity’s sake, they’re referring to the same thing. The large number that currently sits just shy of $28 trillion.
Which sounds scary. Especially to people who’ve experienced debt through student loans, mortgages, auto loans, medical debt, etc. — so, essentially everyone. But, the Federal Deficit is nothing like the personal loans or debt you’ve incurred.
Thus, it’s important to identify the basic truths of federal spending. This is the Too Long Didn’t Read (TLDR) section:
The U.S. Government cannot default on any of its debts. The government is a currency issuer, it has the power to create money to pay off debts.
Yes, the U.S. Government can create money. This is important to repeat and understand.
The U.S. Government does not need to take out loans to finance spending the same way you or I would take out loans.
China cannot “call in’’ its U.S. debts to destabilize our currency. They simply own bonds. The same as other businesses and individuals do.
The U.S. Federal Deficit should never be compared to individual or business debt. They are not the same.
As we approach a post-COVID economy, one which appears to be heading towards a recession, we absolutely will continue to hear about how dangerous and irresponsible it is to add to the National Debt. But the reality is it’s not dangerous, and we’re going to need big-time federal spending to support people, businesses, and hospitals.
That’s why we need to have a conversation about what the Federal Deficit is, and what it is not. Much of the panic that surrounds it is a simple misunderstanding.
Understanding the Federal Deficit
The Federal Deficit is not like your own personal debt. When you take out a mortgage, you are borrowing money from a bank. You have to pay that money back. The bank needs you to pay that money back so they can loan it out to someone else in the future when they want to buy a house. You are both users of currency (dollars).
The U.S. Government is not taking out a loan to pay for things like the military, infrastructure, education, or government employee salaries. Even when they run a deficit, they are not taking out a loan. Why? Because they are currency issuers, they can create money. And that’s exactly what they do.
Central Banks around the world control their own money supply, and the Federal Reserve holds that position in the United States. If they need to “create” money, they simply write a bond and hold it, instead of selling it to a private bank like J.P. Morgan. If they sell the bond to a private bank, they are using already existing money in the money supply, not creating new money.
How has the government-funded the COVID relief packages? By creating money, simply tapping a few keys at the Federal Reserve. This is exactly how they pay for other expenses on an annual basis.
Now, why does this get counted as debt and confused as being something we have to “pay back?” Because of bonds. To create money the government needs to sell bonds, the important part is who buys the bonds.
When the Federal Reserve buys and holds the bonds, this is how the government creates money. The Federal Reserve never has to “call-in” those bonds and force the government to pay them back. Why? The Federal Reserve and government work together. I wouldn’t take money out of my left pocket and put it in my right pocket to “pay back” myself.
Recently, the government sold bonds to the Federal Reserve to finance the $1,200 checks people received over the summer and to support the Paycheck Protection Program (PPP) loans. The government does this to some degree every year because they don’t collect enough taxes to cover their entire spending bill. This is where the Federal Deficit comes from.
The above figure shows how the Federal Deficit is created. The government spends $100 on things like the military, new roads, social security, Medicaid, etc… At the end of the year, the government collects taxes totaling $80. This creates a $20 federal deficit. So where did the money go? It stayed with us. It continues to change hands as we buy groceries, pay rent, or go to the movies.
So who does the government owe this $20 to? We keep hearing that our grandkids have to pay off the huge Federal Deficit. So who exactly are our grandkids paying back? This is the important question.
The answer… the government.
This brings us back to an important point we briefly covered. The government can create money, thus not needing to ever make our grandkids pay them back. If the government were to force our grandkids to pay them back, it would be purely by choice, never by necessity.
If we elected a president who committed to “paying off the National Debt,” like so many have claimed, it would mean they start taxing people more than the government spends. But why would they do that? Let’s remember, we the people did not take a loan out from the government for $100 and then only pay back $80. The government decided to spend $100, and decided to tax out $80.
This isn’t to say that raising taxes above $100 in this example (or total spending) is bad. It can be useful in combating inflation during a strong economy. But there’s no set date on which the government decides we need to “pay back” the National Debt.
As we’ve covered, the government has the power to create money by selling bonds to the Federal Reserve. The Federal Reserve has the power to hold onto those bonds forever. They never come to the government, knock on the door, and ask for payment plus interest. Again, the Federal Reserve works for the government.
Now if a local bank were to buy a government bond, yes, the bank would get paid back at a determined time in the future. But the Federal Reserve does not operate like a local bank. A bond sold to the Federal Reserve is not the same as a bond sold to your local bank. Your local bank does not have the power to create money.
We’ve now covered what the Federal Deficit is not. It’s not a collection of loans that need to be paid back like I have to pay back my student loans. So, what is the Federal Deficit?
How Should We View the Federal Deficit?
The Federal Deficit is simply a balance sheet of government spending. It tracks when and how much money was spent in previous years. It would take our example above with a $20 deficit, and simply add it to the balance sheet at year’s end, and then adjust the total deficit (or surplus) depending on the previous year’s balance.
The current Federal Deficit, of nearly $28 trillion, simply means the U.S. Government has invested $28 trillion more into the economy than it has taken out. The most common way to reduce this number is to ensure that taxation is greater than government spending. Translated to present-day, amid a pandemic, this would only accelerate the looming recession.
Does this mean the government has the power to create as much money as they want? Well, technically yes. But nobody should advocate that because it would cause real problems, unrelated to the Federal Deficit.
Creating money that has no purpose would lead to inflation. The number of the Federal Deficit does not impact inflation. The money being used in an economy to buy goods and services impacts inflation, not the number on a balance sheet.
However, this leads some to conclude that the Federal Deficit doesn’t have any significance. The dollar amount is not important. The important thing is managing the money supply and inflation. Inflation has real-world implications, the Federal Deficit does not.
Lastly, I need to paint the full picture so as not to mislead anyone on exactly how the Federal Deficit is created. The Federal Reserve does not own $28 trillion in bonds to outside sources. However, there absolutely are businesses and individuals who own bonds, thus leaving the U.S. Government with debt.
Wait, So the Government Actually Does Have Debt Then?
Yes, the government does have debts it needs to pay back. However, that number is not the scary-looking $28 trillion Federal Deficit. This debt is also in the form of bonds, however, they’re bonds the government decided not to sell and hold at the Federal Reserve.
The bonds the government has to pay back are the ones that end up in the hands of businesses and individuals. Some of these businesses are located overseas, like say, China. So yes, it’s accurate to say the U.S. owes China money. But in reality, it means Chinese businesses who traded with U.S. businesses took their remaining dollars and traded them in for bonds our government issued.
This is not the same as stating the U.S. calls China and asks for a loan in U.S. dollars. China does not have the power to create dollars, only our government does. Remember, the government does not finance spending by borrowing money from foreign countries. It does however sell bonds to foreign businesses. These two things are not the same, but instead gives an inaccurate impression of the Federal Deficit and U.S. debt.
It’s important to reiterate here, the U.S. will never default on bonds held by individuals or businesses, whether domestic or foreign. The U.S. always has the option to issue new bonds, sell and hold them at the Federal Reserve, and use that newly created money to pay off debt (bonds) held by non-government entities.
Now, there most certainly will come a day when the government decides it makes economic sense to reduce the Federal Deficit. Presidents in the past have thought this. Unfortunately, their doing so at a rapid rate sucked too much money out of the economy (people’s pockets) and brought on depressions.
We should never actively try and reduce the Federal Deficit for the sole purpose of reducing it. It should only be a by-product of tax policy used to control inflation or other negative economic factors.
Said another way, we should never reign in government spending because of the fear of raising the deficit. Especially now, as tens of millions remain out of work during a pandemic that has forced people out of work and businesses to close.
