How Does a Government Borrow Money from Itself?

Popular perception often frames government borrowing as an operation akin to lending from one pocket to another, with the promise of eventual repayment. However, this perspective may be oversimplifying the complex mechanisms at play. For governments with their own currencies, such as the United States, the process of borrowing is more akin to creating money out of thin air. This article seeks to elucidate this process and the rationale behind it, dispelling the notion of borrowing as a household debt equivalent.

The Misnomer of Borrowing

Consider the following: I give you ten green dollars, and you in turn sell me a yellow dollar that is worth ten green dollars plus a little interest. When the interest is paid later, it comes from the green dollars I make myself. In this scenario, I am the government, and you are a citizen, a bank, or another financial institution. This exchange does not truly constitute borrowing in the traditional sense. Instead, it is a means of creating money.

The Mechanism Behind Government Borrowing

While the term "borrowing" may be a misnomer, governments with their own currencies do have the power to issue and spend their own currency. In the United States, the Treasury issues bonds, and the private sector buys these bonds. The proceeds from the sale of these bonds are then spent back into the economy. This process results in an increase in the number of government bonds held by the private sector as assets, an increase in aggregate demand, and no change in the overall number of dollars in circulation.

The central bank, also known as the Federal Reserve (Fed), adjusts the number of reserves held by private sector banks through the purchase or sale of bonds or other assets, such as mortgage-backed securities (MBSs). This adjustment serves as a tool for implementing monetary policy.

Understanding the Government as a Monetarist Entity

When considering the government in tandem with the central bank (Treasury and Fed), the government issues liabilities (bonds and reserves) to fund its spending. Under the current system, these liabilities never need to be extinguished, as they are continually created and managed. Commercial banks act as conduits rather than lenders, and bond issuance is a policy choice rather than an operational necessity.

Contact with Household Finance

To clarify this concept, let's draw a parallel with household finance. If you gave your neighbor a hundred dollar bill, and the neighbor in return promised to give it back with a twenty dollar charge, and then you told the neighbor you would create your own hundred dollar bills to pay this charge, it would be clear that this is not a full-loan scenario. In a similar manner, the government is not borrowing in the traditional sense, but rather creating its own money.

The Real Cost of Government Borrowing

Some people argue that creating money out of thin air could lead to inflation, as more money chasing the same amount of goods could devalue the currency. However, in practice, the economy's ability to meet the added demand (the so-called "real resources") acts as a natural limit to this process. Furthermore, the issuance of bonds coupled with deficit spending results in a net gain of financial assets for the private sector, with no real cost to the government in terms of resource depletion.

The Role of the Federal Reserve

Finally, the Federal Reserve remits any excess profits from the sale of bonds back to the Treasury. This process ensures that the government does not have to pay for these profits from its budget, thus cementing the illusion that the government is not incurring debt.

Conclusion

Government borrowing, as currently practiced, is not a traditional form of debt, but rather a mechanism for creating money. The process is complex and involves both the Treasury and the Federal Reserve working together to manage economic impacts and ensure long-term stability. By understanding this process, we can better appreciate the tools available to governments in managing economic outcomes and meeting their fiscal needs.