The First of Seven Deadly Innocent Frauds

DIF:
The government must raise funds through taxing or borrowing in order to spend.  In other words, government spending is limited by the government’s ability to tax or borrow.

Fact:

The actual act of Government spending is NOT operationally limited or in any way constrained by taxing or borrowing. 

Ask any congressman (as I have many times), or private citizen, how it all works, and he will tell you emphatically that:

“…the government has to either tax or borrow to get funds to spend, just like any household has to somehow get the money it needs to spend.”

And from this comes the inevitable question about healthcare, defense, social security, and everything else:

‘How are you going to pay for it?!’

This is the killer question, the one no one gets right, and getting the answer to this question right is the core of the public purpose behind writing this book. 

In the next few moments of reading it will all be revealed to you with no theory and no philosophy- just a few hard, cold facts.

I answer this question by first looking at exactly how government taxes, followed by how government spends.

HOW GOVERNMENT TAXES

Let’s start by looking at what happens should you go to the Federal Reserve (“the Fed”) to pay your taxes with actual cash.  

First, you hand over a pile of currency to the Fed as payment.

Next, the Fed counts it, and then gives you a receipt and a thank you for helping to pay for social security, the interest on the national debt, and the Iraq war. 

Then, as you, the tax payer, leave the room and close the door behind you, they take that hard earned cash you just forked over and

They throw it in a shredder. 

Yes, they throw it away.  Destroy it!  Why?

They have no further use for it.  Just like a ticket to the Super Bowl.  As you go into the stadium, you hand the man a ticket that was worth maybe $1000, and then he tears it up and throws it away.

So if government throws away your cash after collecting it, how does that cash pay for anything, like Social Security and the rest of the government’s spending? 

It doesn’t.  Something else is going on. 

Now let’s look at what happens if you pay your taxes by writing a check.   

When the government gets your check, and your check is deposited and ‘clears,’ all the government does is change the number in your checking account ‘downward’ when they subtract the amount of your check from your bank balance.

Does the government actually get anything real to give to someone else?  No, it’s not like they get a gold coin to spend. 

You can actually watch this happen with online banking.  You can see the balance in your bank account on your computer screen. 

Suppose the balance in your account is $5,000 and you write a check to the govt. for $2,000. 

When that checks clears, what happens?  The 5 turns into a 3, and your new balance is now down to $3,000.  All before your very eyes!

And all they did was change a number in your bank account. 

The government didn’t actually ‘get’ anything to give to someone else. 

No gold coin dropped into a bucket at the Fed. 

All they did was change numbers in bank accounts.  Nothing ‘went’ anywhere. 

(Can you now see why it makes no sense at all to say the government has to get money by taxing in order to spend?)

So if govt. doesn’t actually get anything when it taxes, how and what does it spend?

HOW GOVERNMENT SPENDS

Imagine you are expecting your $2,000 social security payment to hit your bank account which already has $3,000 in it, and you are watching your account on your computer screen.  You are about to see how government spends without having anything to spend. 

Presto! 

Suddenly your account statement that read $3,000 now reads $5,000.  What did the government do to give you that money? 

It simply changed the number in your bank account from 3,000 to 5,000.  It changed the 3 into a 5.  That’s all.  It didn’t take a gold coin and hammer it into a computer.  All it did was change a number in your bank account by making data entries into its own spread sheet which is linked to other spread sheets in the banking system. 

Government spending is all done by data entry on its own spread sheet we can call ‘The US dollar monetary system.’   

And even if the government paid you with actual cash, that cash is nothing more than the same data, but written on a piece of paper rather than entered into a spread sheet. 

And how about this quote from the good Fed Chairman on 60 minutes for support:

(PELLEY) Is that tax money that the Fed is spending?

(BERNANKE) It’s not tax money. The banks have– accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed.¹

The Chairman of the Federal Reserve is telling us in plain English that they give out money (spend and lend) by changing numbers in bank accounts.  There is no such thing as having to ‘get’ taxes (or borrow) to make a spread sheet entry that we call ‘Government spending.’  Computer data doesn’t come from anywhere.  Everyone knows that!    

Where else do we see this happen?  Your team kicks a field goal and on the scoreboard the score changes from, say, 7 point to 10 points.  Does anyone wonder where the stadium got those three points?  Of course not!  Or you knock down 5 pins at the bowling alley and your score goes from 10 to 15.  Do you worry about where the bowling alley got those points?  Do you think all bowling alleys and football stadiums should have a ‘reserve of points’ in a ‘lock box’ to make sure you can get the points you have scored?  Of course not!  And if the bowling alley discovers you ‘foot faulted’ and lowers your score back down by 5 points, does the bowling alley now have more score to give out?  Of course not!

 

We all know how ‘data entry’ works, but somehow this has gotten all turned around upside down and backwards by our politicians, media, and most all of the prominent main stream economists.

Just keep this in mind as a starting point:

The Federal Government doesn’t ever ‘have’ or ‘not have’ any dollars. 

Just like the stadium doesn’t ‘have’ or ‘not have’ points to give out. 

When it comes to the dollar our Government is the score keeper.  (And it also makes the rules!)

You now have the operational answer to the question:

‘How are we going to pay for it?’

Answer- the same way government pays for anything- it changes the numbers in our bank accounts.

Government isn’t going to ‘run out of money’ as our President has repeated.  It is not dependent on China or anyone else, as discussed later in this book.  There is no operational limit to how much Government can spend, when it wants to spend.  This includes making interest payments and Social Security and Medicare and Medicaid payments.  It includes all Government payments made in dollars to anyone. 

This is not to say exess government spending won’t possibly cause inflation. 

It is to say the government can’t go broke and can’t be insolvent or bankrupt.  There is simply no such thing.

***I know you’ve got this question on your mind, right now.  I answer it a bit later in this book, but let me state the question and give you a quick answer to tide you over:

If the govt. doesn’t tax because it needs the money to spend, why tax at all?

Answer:  The govt taxes to regulate what economists call ‘aggregate demand’ which is a fancy word for ‘spending power’   In short, that means that if the economy is ‘too hot’ raising taxes will cool it down, and if it’s ‘too cold’ cutting taxes will warm it up.  Taxes aren’t about getting money to spend, they are about regulating our spending power to make sure we don’t have too much and cause inflation, or too little which causes unemployment and recessions.****

So why does no one in government seem to get it?  Why does the Ways and Means Committee in Congress worry about ‘how are we going to pay for it’? 

One reason might be because they are stuck in the popular notion that the government, just like any household, must somehow first ‘get’ money to be able to spend it.

Yes, they have heard that it’s different for a government, but they don’t believe it, and there’s never a convincing explanation that makes sense to them.

What they all miss is the difference between spending your own currency that only you create, and spending a currency someone else creates. 

So to properly utilize this popular government/household analogy in a meaningful way, we next look at an example of a ‘currency’ created by a household. 

The story begins with the parents creating coupons they then use to pay their children for doing various household chores.  

  

Additionally, to ‘drive the model,’ the parents require the children to pay them a tax of 10 coupons a week to avoid punishment. 

This closely replicates taxation in the real economy, where we have to pay our taxes or face penalties.

The coupons are now the new household currency.  Think of the parents as ‘spending’ these coupons to purchase ‘services’ (chores) from their children. 

With this new household currency, the parents, like the government, are now the issuer of their own currency. 

And now you can see how a household with its own currency is indeed very much like a government with its own currency.

Let’s begin by asking some questions about how this new household currency works.

Do the parents have to somehow get coupons from their children before they can pay their coupons to their children to do chores? 

Of course not! 

In fact, the parents must first spend their coupons by paying their children to do household chores, to be able to collect the payment of 10 coupons a week from their children.  How else can the children get the coupons they owe the parents?

Likewise, in the real economy, the Federal Government, just like this household with its own coupons, doesn’t have to get the dollars it spends from taxing or borrowing, or anywhere else, to be able to spend them. With modern technology, the Federal Government doesn’t even have to print the dollars it spends the way the parents print their own coupons.

Remember, the Federal Government itself neither has nor doesn’t have dollars, any more than the bowling alley ever has a box of points.  

And how many coupons do the parents have in the parent/child coupon story?  It doesn’t matter.  They could even just write down on a piece of paper how many coupons the children owe them, how many they’ve earned, and how many they’ve paid each month.    

When the Federal Government spends, the funds don’t ‘come from’ anywhere any more than the points ‘come from’ somewhere at the football stadium or the bowling alley.

Nor does collecting taxes (or borrowing) somehow increase the government’s ‘hoard of funds’ available for spending.

In fact, the people at the US Treasury who actually spend the money (by changing numbers on bank accounts up) don’t even have the phone numbers of the people at the IRS who collect taxes (they change the numbers on bank accounts down), or the other people at the US Treasury who do the ‘borrowing’ (issue the Treasury securities).

If it mattered at all how much was taxed or borrowed to be able to spend, you’d think they at least would know each other’s phone numbers!  Clearly, it doesn’t matter for their purposes.

From our point of view (not the government’s) we need to first have US dollars to be able to make payments.  Just like the children need to earn the coupons from their parents before they can make their weekly coupon payments. 

In fact, as a point of logic, the dollars we need to pay taxes must, directly or indirectly, from the inception of the currency, come from government spending (or government lending, which I'll discuss later).     

Now let’s build a national currency from scratch.

Imagine a new country with a newly announced currency. 

No one has any. 

Then the government proclaims, for example, a property tax. 

How can it be paid? 

It can’t, until after the government starts spending. 

Only after the government spends its new currency does the population have the funds to pay the tax. 

To repeat, the funds to pay taxes, from inception, come from government spending (or lending).  Where else can they come from???  ²

FootNote 2, displayed here in the draft: For those of you who understand reserve accounting, note that the Fed can’t do what’s called a reserve drain without doing a reserve add.  So what does the Fed do on settlement day when Treasury balances increase?  It does repos, to add the funds to the banking system that banks then have to buy the Treasury Securities.  Otherwise, the funds aren’t there to buy the Treasury securities, and the banks will have overdrafts in their reserve accounts.  And what are overdrafts at the Fed?  Functionally an overdraft is a loan from the government.  So, again, one way or another, the funds that are used to buy the Treasury securities come from the government itself. 

And because the funds to pay taxes, or buy government securities, come from government spending, the government is best thought of as spending first, and then collecting taxes or borrowing.  

Yes, that means the government had to spend first, to ultimately provide us with the funds we need to pay our taxes.

The government, then, is just like the parents have to spend their coupons first, before they can start actually collecting them from their children.

And, neither the government, nor the parents, from inception, can collect more of their own currency than they spend.  Where else could it possibly come from?

***Note on how this works inside the banking system:

When you pay taxes by writing a check to the Federal Government, they debit your bank’s reserve account at the the Federal Reserve.  Bank reserves can only come from the Fed.  The private sector can’t generate them.  If your bank doesn’t have any, the check you wrote results in an overdraft in that bank’s reserve account. An overdraft is a loan from the Fed. So in any case the funds to make payments to the Federal Government can only come from the Federal Government.***

So while our politicians truly believe government needs to take our dollars, either by taxing or borrowing, for them to be able to spend, the truth is:

We need the Federal Government’s spending to get the funds we need to pay our taxes.

[FootNote3 :Just a quick reminder that our State governments are users of the US dollar, and not the issuers like the Federal government is.  In fact, the US States are in a similar position as the rest of us- we and the States both need to get funds into our bank accounts before we write our checks, or those checks will indeed bounce.  In the parent/children analogy, we and the States are in much the same position the children are in.]

We don’t get to change numbers like the government does (or the bowling alley and the football stadium). 

Our children have to earn or somehow get their coupons to make their coupon payments, just like we have to earn or somehow get US dollars to make our payments. 

And, as you now understand, this is just like it happens in any household that issues its own ‘coupons.’  The coupons the kids need to make their payments to their parents have to come from their parents.

And, as previously stated, government spending is in no case operationally constrained by revenues (tax payments and borrowings).  Yes, there can be and there are ‘self imposed’ constraints on spending by Congress, but that’s an entirely different matter.   These include debt ceiling rules, Treasury overdraft rules, and restrictions of the Fed buying securities from the Treasury.  They are all imposed by a Congress that does not have a working knowledge of the monetary system.  And, with our current monetary arrangements, they are all counterproductive with regard to furthering public purpose.  All they do is put blockages in the monetary plumbing that wouldn’t otherwise be there, and from time to time create problems that wouldn’t otherwise arise.  In fact, it was some of these self imposed blockages that caused the latest financial crisis to spill over to the real economy and contribute to the recession.

The fact that government spending is in no case operationally constrained by revenues means

there is no ‘solvency risk-’

the government can always make any and all payments in its own currency, no matter how large the deficit is, or how few taxes it collects.

This, however, does NOT mean the government can spend all it wants without consequence. 

If it spends too much more than it ‘makes room for’ by taxing us, it can create a lot of inflation.

What it does mean is there is no solvency risk. 

There is no such thing as our government ‘running out of money to spend’ as President Obama has incorrectly stated repeatedly.  Nor, as President Obama also stated, is US spending limited by what it can borrow. 

So next time you hear ‘where will the money for social security come from’ go ahead and tell them- it’s just data entry.  It comes from the same place as your score at the bowling alley comes from. 

Putting it all yet another way, government checks don’t bounce, unless the government decides to bounce its own checks.

Government checks don’t bounce. 

A few years ago I gave a talk in Australia at an economics conference.  The title was ‘Government Checks Don’t Bounce.’  In the audience was the head of research for the Reserve Bank of Australia, a Mr. David Gruen.  This was high drama.  I had been giving talks for several years to this group of academics and I had not convinced most of them that government solvency wasn’t an issue.  They always started with the familiar ‘What Americans don’t understand is that it’s different for a small, open economy like Australia than it is for the United States.’  There seemed to be no way to get it through their perhaps overeducated skulls that at least for this purpose none of that matters.  A spread sheet is a spread sheet.  All but Professor Bill Mitchell and a few of his colleagues seemed to have this mental block, and so they deeply feared what would happen if ‘the markets’ turned against Australia to somehow keep them from being able to ‘finance the deficit.’

So I began my talk about how government checks don’t bounce, and after a few minutes David’s hand shot up with the statement familiar to all modestly advanced economic students: 

‘If the interest rate on the debt is higher than the rate of growth of GDP, than the government’s debt is unsustainable.’ 

It wasn’t even a question.  It was presented as a fact.

I then replied ‘I’m an operations type of guy, David, so tell me, what do you mean by the word unsustainable?’  Do you mean that if the interest rate is very high, and 20 years from now the government debt has grown to a large enough number the government won’t be able to make its interest payments?  And if it writes a check to a pensioner that check will bounce?’

David got very quiet, deep in thought, and said while he was thinking it through ‘you know, when I came here, I didn’t think I’d have to think through how the Reserve Bank’s check clearing works’ in an attempt at humor.  But no one in the room laughed or made a sound.  They were totally focused on what his answer might be.  Again, this was high drama - it was the ‘showdown’ on this issue.

David finally said ‘no, we’ll clear the check, but it will cause inflation and the currency will go down.  That’s what people mean by unsustainable.’ 

There was dead silence in the room.  The long debate was over.  Solvency is not an issue, even for a small, open economy.  Bill and I instantly commanded an elevated respect, which took the usual outward form of ‘well of course, we always said that’ from the former doubters and skeptics.    

I continued with David, ‘Well, I think most pensioners are concerned about whether the funds will be there when they retire, and whether the Australian government will be able to pay them.’  To which David replied, ‘No, I think they are worried about inflation and the level of the Australian dollar.’  To which Professor Martin Watts, head of the economics department at the University of Newcastle replied, ‘The Hell they are, David!’  To which David very thoughtfully replied, ‘Yes, I suppose you’re right.’

So what actually was confirmed to the Sydney academics in attendance that day?  Governments using their own currency can spend what they want when they want, just like the football stadium can put points on the board at will.  The consequences of overspending might be inflation or a falling currency, but never bounced checks. 

The fact is:

Government deficits can never cause a government to miss any size payment.  There is no solvency issue.  There is no such thing as running out of money when spending is just changing numbers upwards in bank accounts at your own central bank.

Yes, households, businesses, and even the states need to have dollars in their bank accounts when they write checks, or those checks can bounce. That’s because the dollars they spend are created by someone else—the Federal Government.

So why does government tax us, if it doesn’t actually get anything to spend?

Hint: It’s the same reason the parents demand 10 coupons a week from their children, when the parents don’t actually need the coupons for anything.

 

There is a very good reason they tax us.

Taxes create an ongoing need to get dollars and therefore an ongoing need for people to work to get dollars. 

And guess who does all this in the first place to get people to work for it and sell it the goods and services it needs?

Right, the federal government! 

Just like the coupon tax on the children creates an ongoing need for them to need coupons and do chores for the parents to get them.

Think of a property tax. (You’re not ready to think about income taxes—it comes down to the same thing, but it’s a lot more indirect and complicated). You have to pay the property tax in dollars or lose your house. It’s just like the kids situation, where the need to get 10 coupons or face the consequences.

So now you are motivated to sell things—goods, services, your own labor—to get the dollars you need. It’s just like the kids, who are motivated to do chores to get the coupons they need.

Finally, I have to connect the dots from some people needing dollars to pay their taxes to everyone wanting and using dollars for almost all of their buying and selling.  To do that, let’s go back to the example of a new country, with a new currency I’ll call “the crown”, where the government levies a property tax.

Let’s assume the government levies this tax for the further purpose of raising an army, and offers jobs to soldiers who are paid in “crowns”.  

Suddenly, a lot of people who own property now need to get crowns, and many of them won’t want to get crowns directly from the government by serving as soldiers. So they start offering their goods and services for sale in exchange for the new crowns they need and want, hoping to get these crowns without having to join the army.

Other people now see many things for sale they would like to have—chickens, corn, clothing, and all kinds of services like haircuts, medical services, and many other services. The sellers of these goods and services want to receive crowns to avoid having to join the army to get the money they need to pay their taxes.

The fact that all this other stuff is being offered for sale in exchange for crowns makes some other people join the army to get the money needed to buy some of those goods and services.  

In fact, prices will adjust until as many soldiers as the government wants are enticed to join the army.  Because until that happens, there won’t be enough crowns spent by the government to allow the taxpayers to pay all of their taxes, and those needing the crowns who don’t want to go into the army will cut the prices of their goods and services as much as they have to in order to get them sold, or else thow in the towel and join the army themselves. 

This is not merely a theoretical example. It’s exactly what happened in Africa in the 1800’s when the British established colonies there to grow crops. The British offered jobs to the local population, but none of them were interested in earning British coins. So the British placed a “hut tax” on all their dwellings, payable only in British coins. Suddenly, the area was “monetized,” as everyone now needed British coins, and the local population started offering things for sale to get the needed coins, including offering their labor for sale.  The British could then hire them and pay them in British coins to work the fields and grow their crops.

And this is exactly what the parents did to get labor hours from their children to get the chores done.

And that’s exactly how all of what are called non convertible currencies work, like the US dollar, the Japanese yen, and the British pound.

Now we’re ready to look at the same thing from a different angle, that of today’s economy, using some of the language of economics.

A learned economist today would say that “taxes function to reduce aggregate demand.” Their term aggregate demand is just a fancy term for “spending power.”

The government taxes us and takes away our money for one reason—so we have that much less to spend which makes the currency that much more scarce and valuable.

Taking away our money can also be thought of as leaving room for the government to spend without causing ‘inflation.’ 

Think of the economy as one big department store full of all the goods and services we all produce and offer for sale every year.  We all get paid enough in wages and profits to buy everything in that store, assuming we spent all the money we earned and all the profits we made.  (And if we borrow to spend we can buy even more than there is in that store.)

But some of our money is going to pay taxes, leaving us short of the spending power we would need to buy all of what’s for sale in the store. So if government taxes us and doesn’t spend anything (and we decide not to go into debt to buy things), there would be a lot of goods and services in that store going unsold.  People would lose their jobs, and we would go into a recession.

This is what happens when the government taxes too much relative to its spending, and total spending isn’t enough to make sure everything in the store gets sold. 

Keep in mind the public purose behind government doing all this is to raise an army, operate a legal system, support a legislature and executive branch of government, promote public infrastructure, promote basic research, etc.  So there is quite a bit that even the most conservative voters would have the government do.     

So I look at it this way-

for the ‘right’ amount of government spending which we presume is necessary to run the nation the way we would like to see it run, how high should taxes be?

The reason I look at it this way is because the ‘right amount of government spending’ is an economic and political decision that, properly understoon, has nothing to do with government finances.  The real ‘costs’ of running the government are the real goods and services it consumes- all the labor hours, fuel, electricity, steel, carbon fiber, hard drives, etc. etc. etc.  The real cost of the government using all these real goods and services is that those resources would other wise be available for the private sector.  So when they government takes those real resources for its own purposes, there are that many fewer real resources left for private sector activity. 

So, for example, the real cost of the ‘right size’ army with enough soldiers to defend ourselves is that there are fewer workers left in the private sector to grow the food, build the cars, do the doctoring and nursing and administrative tasks, sell us stocks and real estate, paint our houses, mow our lawns, etc. etc. etc. 

Therefore, the way I see it, we first set the size of government at the ‘right’ level, based on real benefits and real costs, and not the ‘financial’ considerations.  The monetary system is the tool we use to achieve our real economic and political objectives, not the source of information as to what those objectives are.  And after deciding what we need to spend to the ‘right sized’ government, we adjust taxes so that we all have enough spending power to buy what’s still for sale in the ‘store’ after the government is done with its shopping.

In general, I’d expect taxes to be quite a bit lower than government spending, for reasons already explained and also for reasons explained later in this book.  In fact, a budget deficit of perhaps 5% of our gross domestic product might turn out to be the norm, which in today’s economy is about $750 billion annually.  However, that number per se is of no particulary economic consequence.  What matters is that taxes are set to balance the economy and make sure it’s not too hot or not too cold.  And government spending is set at the ‘right amount’ given the size and scope of government we want.     

That means just because we are in a slow down, we should not add to the size of government to help the economy.  We should already be at the ‘right’ size for government, and therefore not add to it every time the economy slows down and grow it to the ‘wrong’ size.  So while during a slowdown increasing government spending will indeed make the numbers work, and will indeed end the recession, for me that is far less desireable than accomplishing the same thing with the ‘right’ tax cuts in sufficient size to restore spending to the desired amounts. 

Even worse is increasing the size of government just because the government might find itself in surplus.  Again, government finances tell us nothing about how large government should be.  That decision is rightly and totally independent of government finances.  The right amount of government spending has nothing to do with tax revenues or the ability to borrow, as both of those are but tools for implementing policy, and not reasons for spending or not spending, and not sources of revenue needed for actual government spending. 

I’ll get specific on what role I see for government later in this book, but rest assured my vision is for a far more streamlined and efficient government, that’s intensely focused on the basis of fundamental public purpose.  Fortunately, there are readily available, and infinitely sensible ways to do this.  We can put the right incentives in place that channel market forces with far less regulation and guidance to better promote the public purpose.   This will result in a government and culture that will continue to be the envy of the world.  It will be a government that expresses our American values of rewarding hard work and innovation, and promoting equal opportunity, equitable outcomes, and enforceable laws and regulations we can respect with true pride.          

But I digress.  Returning to the issue of how high taxes need to be, recall that if the government simply tried to buy what it wanted to buy and didn’t take away any of our spending power-no taxes- there would be ‘too much money chasing too few goods’ and the result would be a lot of inflation.  In fact, with no taxes nothing would even be offered for sale in exchange for the government money in the first place, as previously discussed.  

To prevent the government’s spending from causing that kind of inflation, the government must take away some of our spending power by taxing us, so their spending won’t cause inflation. 

In other words, the government taxes us, and takes away our money, to prevent inflation, and not to actually get our money in order to spend it.

Restated one more time-

Taxes function to regulate the economy, and not to get money for Congress to spend. 

And, again, the government neither has nor doesn’t have dollars, it simply changes numbers in our bank accounts upward when it spends, and downwards when it taxes. 

All, presumably, for the further public purpose of regulating the economy.

But as long as government continues to believe this first of 7 deadly innocent frauds- that they need to get money from taxing or borrowing in order to spend, they will continue to support policy that constrains output and employment, and prevents us from achieving what are otherwise readily available economic outcomes.

Intriguing isn't it?  Prior to August 2008 I thought Federal spending worked the same as state, county, city and household spending.   Clearly it is not! 
I know you love this country as much as I do or you would not have read this far.  I don't care who is right I only care what the truth is.  Thank you for visiting. 

Learn about all 7 DIFs here