How does a modern government actually spend? Through keystrokes. Okay. When the government wants to buy something or make a transfer payment or Social Security payment, it credits a bank’s reserves, and
the bank credits your demand deposit. All electronically. That’s the way modern states spend. So they are spending their own money unit
into existence. Taxes just reverse that. The government debits your bank’s reserves, and the bank debits your account. So it’s credits, and debits. And banks, are sort of like our scorekeepers; they keep track of these credits and debits for us. When the government credits more accounts
than it debits, we call that “deficit spending.” That’s what deficit spending is, the government has created more money than it has debited in tax payments. So the government net credits bank reserves, and the bank net credits the account of the recipient. Okay, why does the government sell bonds? The government can buy anything it wants by
crediting bank accounts. Why does it sell bonds? It doesn’t need its own money from the population; it creates its own money every time it spends. It never needs to borrow. In fact, if you look at the balance sheets, there is no way that the currency-issuer can borrow its own currency. That makes no sense at all. And in fact it could not be done. So they don’t “borrow” their own currency. Deficit spending leads to net credits to banking system reserves. This will normally lead to excess reserves. If we’re running a $1 Trillion budget deficit, by identity we’re creating $1 trillion of bank reserves. In normal times, banks don’t want to hold excess reserves, so they offer them in the overnight market (called the Fed Funds market
in the United States). That drives the overnight interest rate down, okay. Potentially to zero. And so what the Fed does, is it sells bonds to drain excess reserves. So bond sales are actually part of monetary policy, and it really doesn’t matter whether it’s the Fed that sells them or the Treasury that sells them, the purpose of selling bonds is to drain excess reserves from the banking system, so that the central bank can hit its overnight interest rate target. Otherwise, the interest rate would be driven to zero. Ok, we’re in unusual times right now, where the Fed WANTS the interest rate to be about zero, so it can leave excess reserves in the banking system, but this is not normal. So really, bond sales have nothing to do with borrowing,
they’re not part of the fiscal operations of the state, they’re part of the monetary policy
operations to hit the interest rate target. And just in parenthesis, a budget surplus is the opposite: you’re always draining the reserves out of the system, you gotta put them back in, you do that through Open Market Purchases. Central bank policy. We’ve had a long history of debate about what
the central bank should do; should it have a money target, should it have an inflation
target, should it have interest rate targets? Ok, economists have finally reached a consensus,
ok (one that we discovered a long time ago), which is that central banks always operate
with an overnight interest rate target. No matter what they tell you, that’s what
they’re actually doing. An overnight interest rate target. And that means that they have to accommodate exactly the demand for reserves, or they’ll miss their target. And that is why they use the bond sales and
bond purchases in order to make sure banks have the right amount of currency reserves. What this means is, that the interest rate
is set by the central bank, and they hit their interest rate target, through the Open Market
Operations. Okay? Now, they set it anywhere they want. If we want zero interest rates, we can have
zero interest rates. It doesn’t matter whether the budget deficit
is $1 trillion, or we have a budget surplus. We can hit our interest rate target. This is not true for a country that is not sovereign in the currency sense that I’m using that term. So, for example, Greece cannot set its interest rate. Okay? It is subject to the bond vigilantes. The United States is not. And neither is Japan. And note Japan has budget deficits even bigger
than ours, and they’ve been doing it for more than 20 years, and had zero interest rates
all along. Because they want them to be zero.