Printing Money

The topic of government finances is back in the limelight once again.  Not only do we have the carnage that is the European Union (I'm trying to be nice), but we also have the USA’s so-called “super-committee” has their deadline coming up, but don’t worry because that’s not today’s topic.  In general, my view of the super-committee is that it’s a hollow effort because it was originally conceived to get both parties past the 2012 election (yes, another delay by our elected officials in dealing with real problems) and even today, an effort to repeal the mandatory cuts or reduce the threshold would somehow fail to surprise me (yes, they’re basically able to change the rules of the road and the objectives of the mission if they don’t like them).  This is why I don’t plan to write much about the topic.

Instead, I want to take this chance to put out a couple posts I worked on back then, but didn’t post.  In my previous debt ceiling discussions, I mentioned that, aside from the ability of a government to print money, there’s not that much of a difference between personal and business finance versus government finance.  In a nutshell, as long as you take in more money than you put out, you’re in good shape, and in both cases, there’s good debt (investment and survival) and there’s bad debt (excess consumption). 

Today, I’m going to talk about that printing money difference.  So, what do we mean when we talk about the government printing money?  This is a very oversimplified explanation, but bear with me.  In the USA, we have the Treasury and the Federal Reserve.  The Fed is ‘in charge of’ our currency, the dollar, so they essentially decide how many dollars they want out there. When the Fed wants more dollars out there, they lower their interest rates, and when they want less dollars out there, they raise rates.  The underlying value of a dollar used to be backed by gold on the gold standard, but we went off that a couple decades ago. 

It’s the Treasury’s job to actually finance the government spending and operations.  They do this in two ways.  First, they collect tax revenues, which makes up about 60% of the money that comes into the Treasury.  Second, they issue Treasury bonds to cover the other 40% or so, which are basically pieces of paper the Treasury sells to a buyer and in exchange, Treasury promises to repay the buyer of the bond a certain amount of money at some future date.  These bonds trade on the markets with various durations and interest rates.  They’ve been doing this for decades, so when the Treasury does their auctions, which they usually do three times per week for various durations, not only are they issuing new bonds, but they’re retiring old bonds. 

Basically, if the government wants to print money, they ramp up the Treasury bond auctions.  And how can a government inflate their way out of debt?  There, the Treasury needs the Fed’s help because the Treasury would need the Fed to lower the dollar’s value. 

Suppose we have X dollars of debt and Y dollars in circulation.  At the moment, the given value of the dollar is Z.  Now, say we increase Y.  Two things happen.  First, assuming whatever collateral, C, is underlying the dollar to back its value remains constant in amount and value itself, Z falls.  Our dollars are now worth less because there are more of them in circulation with an amount of backing that remained constant.  Were we to increase Y while seeking to keep Z constant, we would have to increase the amount and/or value of C.  Simply speaking, Z = C / Y. 

So, we’ve increased Y and held C constant, thereby lowering Z.  But, we have this debt X.  Guess what?  X remains constant.  So, this means we have the same actual number of dollars X in debt, but the value of those dollars, Z, is now lower.  Basically, we’re borrowing money today that we’d repay in the future with less valuable dollars.  Say I borrow $100,000 today and assume Z drops by 1%/year for the next decade.  In a decade, assuming no repayment and no interest in this simple example, today’s $100,000 would be equal to tomorrow’s roughly $110,000 (I know it’s not exact due to percentage compounding).  However, in the future, my debt would still be only $100,000.  Voila.  I’m inflating my way out of debt. 

The US government has been playing this game for decades.  Europe’s been playing this game longer and stronger than we have.  Even corporations and local/state-level governments play this game to a degree in the bond markets (they’ll sell bonds of a certain duration and when that duration is up, they’ll retire the current bonds and issue more new ones). 

Printing money is a big difference between individual and government finance, but the fundamental structures of the two are still very similar.  It’s an important difference to understand.  Because of this ability to print money, the US federal government can’t really go bankrupt in the truest sense of the word like a person, corporation, town, county, or even state could. 

Don’t take this to mean that deficits don’t matter because they most certainly do.  They just matter in a different way for the US government than what we would typically think of for people, corporations, or state/local governments.  Also, don’t take this to mean that we can print money indefinitely without consequences because that’s just not true.  This would get way deeper than I intended into higher-level stuff like Modern Monetary Theory (MMT) and the intricacies and nuances of global economics and finance, so I’ll stop here.