Question #2453

An advantage of fiscal deficits is that the non-government sector becomes immediately wealthier because the sovereign government issues debt to private wealth holders.

• True
• False

Answer #12253

Answer: False

Explanation

The answer is False.

The fundamental principles that arise in a fiat monetary system are as follows.

• The central bank sets the short-term interest rate based on its policy aspirations.
• Government spending is independent of borrowing and the latter best thought of as coming after spending.
• Government spending provides the net financial assets (bank reserves) which ultimately represent the funds used by the non-government agents to purchase the debt.
• Fiscal deficits that are not accompanied by corresponding monetary operations (debt-issuance) put downward pressure on interest rates contrary to the myths that appear in macroeconomic textbooks about 'crowding out'.
• The "penalty for not borrowing" is that the interest rate will fall to the bottom of the "corridor" prevailing in the country which may be zero if the central bank does not offer a return on reserves.
• Government debt-issuance is a "monetary policy" operation rather than being intrinsic to fiscal policy, although in a modern monetary paradigm the distinctions between monetary and fiscal policy as traditionally defined are moot.

National governments have cash operating accounts with their central bank. The specific arrangements vary by country but the principle remains the same. When the government spends it debits these accounts and credits various bank accounts within the commercial banking system. Deposits thus show up in a number of commercial banks as a reflection of the spending. It may issue a cheque and post it to someone in the private sector whereupon that person will deposit the cheque at their bank. It is the same effect as if it had have all been done electronically.

All federal spending happens like this. You will note that:

• Governments do not spend by "printing money". They spend by creating deposits in the private banking system. Clearly, some currency is in circulation which is "printed" but that is a separate process from the daily spending and taxing flows.
• There has been no mention of where they get the credits and debits come from! The short answer is that the spending comes from no-where - some numbers are typed into bank accounts. Suffice to say that the Federal government, as the monopoly issuer of its own currency is not revenue-constrained in its spending. This means it does not have to "finance" its spending, which is unlike a household, which uses the fiat currency.
• Any coincident issuing of government debt (bonds) has nothing to do with "financing" the government spending.

Government spending adds net financial assets denominated in the government's currency to the non-government sector. If that spending is not matched by taxation revenue, then net financial wealth rises in the non-government sector.

So deficits add to non-government sector financial wealth through the spending.

All that bond sales do is provide a risk-free, interest-bearing security (government debt) to the wealth portfolio of the non-government sector.

In other words, the bond sale just offers portfolio choice for the non-government sector rather than changing its net holding of financial assets.

So the debt-issuance does not increase the net financial assets that are held by the non-government sector $-for-$.

Later, as interest payments are made on the outstanding debt, further increments in net financial assets will occur. But the question asks about the immediate impact.

The following blog posts may be of further interest to you:

• Quantitative easing 101
• Building bank reserves will not expand credit
• Building bank reserves is not inflationary
• Money multiplier and other myths
• Will we really pay higher interest rates?
• A modern monetary theory lullaby