Michael Kuehlwein,
As of June of 1990, the gross debt of our federal government was $3.3 trillion. This is such a huge number, most students cannot comprehend it. To help, I tell them that if they spent $1 million per minute 24 hours a day 365 days a year, it would take longer than 6 years to spend $3.3 trillion. That usually stuns even the most avid shoppers in the class.
The FED as the Federal Government's Watchdog
Rona S. Weiss,
To explain the complex, semiautonomous relationship between the Federal Reserve and the central government, I ask my students to imagine that they are on a diet and must therefore control food intake. Therefore, they ask a trusted friend or relative (FED) to stand guard at their refrigerator. Although they asked the guard to control intake of food (money or credit creation) in the morning, when evening television time comes and they want a snack, they find themselves in conflict with this guard whom they have charged with a responsibility that may be both necessary and beneficial to their own survival.
Balanced Budgets and Monetary Growth Rules: Conflicts?
Ralph T. Byrns
The government budget constraint equation may be used to show how a monetary growth rule (any fixed percentage rate of growth in the money supply exceeding zero) and a balanced budget may be incompatible. These two proposals are often supported by the same people. If a monetary growth rule of a fixed 4% annually were adopted today and if the FED used only open market operations as a basis for this growth, in the absence of further budget deficits the entire national debt would be owned by the FED in roughly three decades. If the budget continued to be balanced annually, further monetary expansion would require continually reducing reserve requirements. Once this avenue for expansion was exhausted, the FED might be forced to set the discount rate slightly below the market interest rate, but tightly regulating the growth of the monetary base with this mechanism would be exceedingly difficult.
An
alternative to balancing the budget that would permit open market operations as
the mechanism by which the rate of monetary growth could be regulated would be
to set tax rates so that a tiny budget deficit would typically be run each
year. This would stabilize the national debt and permit a fixed rate of
monetary growth as desired by those who prefer rules to discretionary policy
making. This approach was first suggested in the 1920s by a
Are the FED's Holdings of Federal Debt Meaningful?
Ralph T. Byrns
Remind students that expansionary open market operations entail FED purchases of U.S. Treasury bonds and that the FED is actually an arm of the federal government, regardless of legal fictions to the contrary. Identify your left pocket as the Treasury and your right pocket as the FED. Then pull some money (a big bill will help students remember this point) out of your right pocket. Show it to your class. Stick the bill in your left pocket. Now state that if you were a government accountant, you would alter your books to show that the left pocket (Treasury) owes the right (the FED), say $20.
Now explain that the Treasury does formally (on paper) pay all interest due on the FED's bondholdings. Illustrate this by visibly moving a few coins from your left pocket to your right pocket, showing your students the amount moved. Follow up by explaining that the FED must regularly return its surpluses (annual receipts exceeding 6% of member banks' "stockholdings") back to the Treasury. Visibly move most of the coins that represented "interest payments" back to your left pocket. Ask your students if any of them would ever keep records of how much money was in which of their pockets, and if transferring corresponding payments between pockets makes any sense. Admit that the government does need to keep track of where its money and bonds are, but point out that anyone who asserts that the amount of federal debt held by the FED (roughly 1/3 of the total) represents an external burden is either naive or a demagogue. The point is, of course, that the FED's total holdings of Treasury bonds are strictly internal to the government, and are almost totally irrelevant to private individuals.
H.
This past summer, I took my six year old son, Adam, to a hot air balloon show. The largest balloon was dark green with the word MONEY emblazoned on it in gold letters. Adam asked me about the big green balloon. I said, "That is money. It is made up of those green pieces of paper that your grandparents send you for Christmas and your birthday. But that's not all it's made of. Remember, some of your money is in your bank account. All of your paper money and bank accounts and all of my paper money and bank accounts and all of everyone's paper money and bank accounts are in that big green balloon."
"What makes it go?" Adam asked me. "Does it burn up all our pieces of paper and bank books to make hot air?" "No," I calmly answered. "The only hot air that fuels that balloon is the ability of people, business, and governments to borrow."
"If we wanted to hold our money in our hands, the balloon would have to be deflated," I told him. "To give us our money, the banks, the Federal Reserve banks, and all other organizations that deal with this big balloon would have to make sure their loans were repaid right now. The government would have to slaughter the national debt and give part of it to the banks. We would have to give part of our house and cars to the bank. I don't think I would like to do that."
Adam said that he certainly didn't want to give up his room or his seat in the car. He didn't even want to give up part of his school or the street in front of the house.
We decided that if the balloon collapsed, we would be much worse off than we are now. "But," Adam asked, "why doesn't it just collapse? What if somebody shot it with a gun?" I had to answer that it couldn't collapse because our faith in the dollar would cause it to heal itself. "Remember what the preacher says in church?" I asked. "He says have faith and nothing will be impossible for you. If we have faith in the Almighty Dollar, that big green balloon will keep on getting bigger and bigger."
"Then someday it will just go boom and be all gone," Adam replied to me. I chose not to argue with the logic of a six‑year old.
Public Debt is an Incurable Disease
H.
Many students, as well as other persons, are appalled at the size of the Federal debt. They often believe that something should be done immediately to reduce the debt. I compare reducing the debt to a situation in which an individual is told by his doctor that he has an incurable disease, but the disease can be controlled so that he may live a long and productive life. The only way the disease can be cured is to end the patient's life. Therefore, the cure is worse than the disease. The cures for a large public debt such as printing money, raising taxes, assessments, repudiation, would eliminate the disease of the debt but would cause economic problems more severe than the debt itself. Living with the debt may be better than eliminating it.
Ralph T. Byrns
Discuss whether the massive deficits of 1981‑87 are negative evidence for the suggestion that we were in the upper range of the Laffer curve. Suggest that it is more likely for an individual state or municipality to be in the upper region of a Laffer curve than it is for the federal government. The reason is that very low taxes (especially on businesses) may cause relocations between states raising revenues in states with lower taxes, but this is not as likely at the federal level.
Taxes, Deficits, and the Printing Press
Ralph T. Byrns
Ask students whether rising budget deficits threaten the federal government with bankruptcy. Then discuss:
a. the advisability of a Constitutional amendment that requires annual (each time Earth orbits the sun) budget balance.
b. the proposition that the budget showed balance over the business cycle, with deficits during recessions and surpluses during prosperity.
c. functional finance; the idea that the economy, not the budget per se, should be balanced.
This may be an opportune time for you to mention that federal spending need not be financed strictly by taxes. Borrowing and printing new monetary base are also possibilities. (These are explored in more detail in Chapter 15.) One interesting question for students is to ask them if they would do anything to collect money elsewhere if they had the right to print it. To the "No" response, ask why the federal government collects taxes; it can (through the Federal Reserve System) print money. Students will conclude that federal government spending would cause huge increases in the supply of money and inflation. This raises the point, made by Abba Lerner among others, that the primary reason for federal taxes is their deflationary effect.
Be sure that students understand why a recession may cause a budget deficit (rising transfer payments and shrinking tax revenues). Then discuss the possibility that attempts to eliminate such a deficit may substantially deepen a depression, and could conceivably be self‑defeating, e.g., cutting government purchases may so deflate induced income that revenues from a progressive income tax system actually fall.
Deficits and Increases in the Money Supply
Tracy C. Miller,
Many students have difficulty understanding the connection between deficits and increases in the money supply. This exercise involves the students in role playing to demonstrate how deficits can be funded.
I ask for several volunteers to be wealth holders in the economy, someone to be a government employee and one person to act as the Treasury representative. I play the role of the Federal Reserve. The wealth holders are each given $10,000 in play money.
The following problem is considered: The Treasury needs to pay the government employee and they have run out of money. The student who represents the Treasury is given the task of selling a government security to a member of the public (one of the students who has the play money). I use a facsimile of a $10,000 five‑year treasury bond paying a coupon rate of interest. Upon receipt of payment, the Treasury agent then pays the $10,000 to government employee.
At this point I ask the class what has happened to the money supply. It is obvious to all that this method of financing the deficit has not affected the money supply. I then note that the Treasury will have to use tax money or additional borrowing to pay interest and retire the principle when the security comes due. But I emphasize that this will not cause a change in the money supply.
Next, I introduce the role of the Federal Reserve. Government borrowing puts upward pressure on interest rates so the FED decides to purchase government securities on the open market to reduce interest rates. The FED bids on the outstanding government security, and pays for it by creating the money. To show this I write the dollar amount of the transaction on a blank piece of paper and pay it to the person who purchased the security from the treasury. As the representative of the FED I then obtain ownership of the treasury bond. I emphasize that this is newly created money that the FED is using to purchase the bond. I explain to the class that since the FED is an arm of the government there is no need for the government to pay itself the principle when the security comes due. In effect the government has financed part of the deficit by creating money.
I conclude the discussion by reemphasizing the point made earlier, that the treasury borrowing had no effect on the money supply. It is only if the FED chooses to increase the money supply to maintain an interest rate target that there is any connection between the amount of treasury borrowing and increases in the money supply.
Notes: