Deficits, Debt, and Money: A Primer

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Tony Lima
July 24, 2010

This entry originally began as a discussion of government budget deficits in the U.K., the U.S., and other developed countries.  As I was writing, I realized that many folks first need some basic information.  There’s nothing very complicated in here, but I urge you to read this before the entry on the current situation in North America and Europe.

Are there any three words more often confused in the media?  In economics, the only competition is the ongoing confusion between money and income.  This article will introduce basic – very basic – concepts.  Frankly, no U.S. citizen should be allowed to vote unless they understand this stuff.

First, here are a few definitions.  The government budget deficit is the difference between what the government spends during a year and its tax revenue.  If the government spends more than its tax revenue, we say the government is running a budget deficit.[1]

When the government runs a budget deficit, the difference between spending and revenue is financed by borrowing.  Economists are fond of saying, “the government issues debt to finance the difference between its spending and borrowing.”  Try that phrase the next time you don’t quite pay off a credit card balance at the end of the month:  “I had to issue some debt last month.”  Sounds a lot better than most of the alternatives, doesn’t it?

The government debt is the total net borrowing the government has done since the beginning of the country (1776 for the U.S.).  To add up the government debt, first add all the annual budget deficits.  Then add all the annual budget surpluses (if any).  Remember to start adding in the year in which the current form of government began.  Subtract total surpluses from total deficits and you have the government debt.  This is the amount the government owes those who hold its debt instruments.

The money supply is the quantity of money in circulation in an economy.  Money is anything that is widely accepted in exchange for goods and services in ordinary commercial transactions.  Without going into details,[2] money in most economies includes currency (bills and coins) and total checking account balances.

Money is not the same as income.  Consider a simple example.  Chris gets paid once a month.  At the beginning of each month, Chris’s employer deposits $5,000 into a checking account.  Thus, at the beginning of the month, Chris’s holding of money equals monthly income. But, of course, Chris doesn’t just let that money sit there.  It gets spent.  So, over the course of a month, Chris mostly holds less money than the total income.  And this is the point.  People usually hold less money than their income.[3]

In the U.S. the Federal Reserve system has been delegated the power to create money.  That means the U.S. government only has one option available to finance a budget deficit: borrowing.  Remember, this is called issuing debt.

Issuing debt usually means some form of government bonds.  The U.S. government issues a bewildering array of debt instruments.  I’ll summarize them shortly, but first you need to know something about bonds in general.

A Bond Primer

bond is a promise to make one or more future payments on specified dates.  Most bonds specify the money amount of the bonds.  (Some bonds are indexed for inflation.  The payments they make can change as the inflation rate changes.)  All bonds have two components: the price you pay today (P) and the maturation value (F, also called the face value, par value, and a bunch of other names).

Let’s look at a simple example.  Suppose you pay $9,750 today for a bond that promises to pay you $10,000 one year from now.  Your rate of return (interest rate, yield to maturity) on this bond is ($10,000 – $9,750)/$9,750 = 2.56%.  Since this is a one year bond, 2.56% is also the annual yield.[4]

Some bonds also make regular payments once or twice a year.  These are called coupon payments (often misleadingly called “interest payments”).  Coupon payments make the analysis of a bond more complicated, but the principal is the same.

The U.S. government issues three basic classes of debt.  Treasury bills (T-bills) mature in one year or less.  The times to maturity are 30 days, 90 days, 180 days, and one year.  Treasury notes mature in between one and ten years.  The ten-year Treasury note was once the benchmark for long-term debt in the U.S.

U.S. government bonds that mature in more than ten years are called Treasury bonds.  The longest bond the government issues is 30 years.  Today this is the benchmark bond for long-term securities in the U.S.

Not One Printing Press, But Two

There’s actually a point to all this.  Think of it this way: the U.S. Department of the Treasury has a printing press.  But it can only print U.S. government bonds.  In the U.S. there’s a second entity that has a printing press that prints money: the Federal Reserve System (the Fed).[5] Contrary to popular belief, the Federal Reserve is not officially part of the U.S. government.  Without going into details, let’s just say it would take an act of Congress for the government to take control of the Fed.[6]

So the U.S. government can’t “print money” to finance its deficit.  It’s up to the Fed to decide how much of the newly-issued debt should be purchased with newly-created money.[7]

So what’s the government debt?  Nothing more than the sum of all the previous government budget deficits.  Naturally, you have to subtract government budget surpluses, but there are only a few of those so it won’t be much of a problem.

The government budget deficit for any year is the net amount of new borrowing done by the government during that year.  The government debt is the total amount the government owes.

Wait – who does the government owe the debt to?

Anyone can buy U.S. government debt.  China’s central bank owns more than $1 trillion of it.[8] The table below shows ownership in 2009.[9]

Who Owns U.S. Government Debt?

Who Owns U.S. Government Debt?

 

The reason the Fed owns so much government debt is simple.  When the Fed wants to increase the money supply, they usually purchase government debt using newly-created money.  But the number that catches your eye immediately is “foreign and international.”  Part of that is owned by foreign central banks, including China’s.

Conclusion

Now that you have some understanding of how the U.S. government’s budget works, you’re ready to handle the debt problem in euro-land.  Read the next blog entry here.  There are two key, related issues.  The first is the total amount of government debt relative to GDP.  The second is the government’s budget deficit relative to GDP.  For the U.S. and U.K. the government debt is about 60 percent of GDP. For Italy and Japan, debt exceeds 100 percent of GDP.  Looking at the deficit as a percentage of GDP for 2009, Greece,  the U.S., the U.K., and Japan were all above 10 percent of GDP.

What does this mean?  Both more and less than you think.  First, looking at the debt relative to GDP is a kind of payback period analysis that answers this question:  “If all the productive resources of our society were used to pay off the government debt, how long would it take?  If the debt to GDP ratio is 50 percent, it would take 6 months (half a year) to pay off the debt.  The deficit as a percentage of GDP gives us some idea of how fast the government is adding debt relative to the growth rate of GDP.


[1] Once upon a time, the U.S. government ran a budget surplus.  That’s what we call the case when the government’s tax revenue exceeds its spending.  Unfortunately, like the unicorn, government budget surpluses are very scarce these days.  Norway remains an interesting exception.

[2] Credit cards are part of the details.  If you really want to know about how credit cards affect the money supply, send me an e-mail.  Warning: most, if not all, money and banking textbooks get this wrong.

[3] There are, of course, those exceptional individuals who save part of their incomes.  Saving will be placed in non-money instruments (like bonds).

[4] Note that interest is earned on the purchase price, not the face value.  This is consistent with the rest of the theory of the time value of money.

[5] Don’t confuse the Fed with the Feds.  The latter are Treasury Agents.  They carry guns and badges.  Most of the folks at the Fed don’t carry guns.

[6] The Federal Reserve Act of 1913 explicitly makes the Fed independent.  Congress would basically have to repeal this law to get control of the Fed.

[7] This is emphatically not true in many other countries.  Central bank independence from government turns out to be a significant factor in keeping inflation rates low.

[8] http://www.nytimes.com/2009/01/08/business/worldbusiness/08yuan.html.  Accessed July 21, 2010.

[9] http://www.fms.treas.gov/bulletin/b2010_2ofs.doc.  Accessed July 21, 2010.

2 Replies to “Deficits, Debt, and Money: A Primer”

  1. Daniel

    Great post Prof!

    Although I´m not sure if there is a real independence of the central banks(especially the FED), by having multiple tasks a the same time (accurate money supply maximum of employment).In the words of The Board of Governors (1994):

    „The Federal Reserve System is considered to be an independent central bank. It is so,
    however, only in the sense that its decisions do not have to be ratified by the President
    or anyone else in the executive branch of government. The entire System is subject to
    oversight by the U.S. Congress because the Constitution gives to Congress the power
    to coin money and set its value — a power that, in the 1913 act, Congress itself delegated
    to the Federal Reserve. The Federal Reserve must work within the framework of the
    overall objectives of economic and financial policy established by the government, and
    thus the description of the System as ’independent within the government’ is more accurate.“

    Not to mention the lack of independence of the current ECB,buying any junk rated gov.bonds they can get..Looking forward to read your next post (might be good to explain the CDS too,seems like many people don´t see their economic justification).

    Daniel Lappas

  2. Tony Lima

    The ECB is facing conflicting objectives: keep inflation under control while, at the same time, keeping the euro zone intact. As we will soon discover, these two goals are incompatible.

    Fed independence is, of course, only a function of Congressional willingness to let the Fed continue to do its job. But I gotta point out that every time a bill is introduced to restrict the Fed, it somehow gets defeated. The banking industry (and most of the rest of us) are truly fearful of what would happen if Congress controlled the monetary printing presses.