Money Mechanics

Money: Nutshell Mechanics and the Significance of the Debt Ceiling

Premise: Government functions. It does things. It must pay for its buildings, for roads, for its military, for its functionaries, for farmers’ subsides, for welfare projects …

1. Primitive government finance.

Government (its treasury) pays its bills with printed certificates (called currency) These certificates are promissory notes. The promise is to redeem them – to accept them in payment of any obligation to the government. For example, it promises to accept these same notes in payment of tax obligations.

A balanced budget is when the Government collects in taxes as much as it spends. Naturally the Government is loathe to collect taxes because tax collection makes the Government unpopular. So it tends simply to print whatever currency it needs to pay its bills. Doing this causes the currency to lose value. When the supply of circulating currency rises, each unit is worth less in goods or services. The steady loss of currency value is called inflation.

2. Modern government finance.

In modern times the printing of money is not something that the government does directly. Until a Central Bank was created in the U.S. most any bank at all issued currency. They had ‘bank notes’ printed. Each bank issued its own notes. To ‘issue’ means to ‘pay with’. They ‘paid’ (made their loans, bought supplies, paid employees) with their bank notes. These were promissory notes; promises to pay on demand. To pay what? Answer: specie or gold, but more importantly, the promise was to redeem the note. To redeem the note means to accept it in payment of any debt to the bank. For example the interest payment to the bank on a mortgage it holds.

These bank notes functioned as money in the community. They were generally accepted in payment for goods or services since the holder could, in turn, use the bank notes to pay his or her own bills. The notes of different banks were exchangable via exhange rates between them. Like exchange rates between different national currencies today.

Currently the U.S. Central Bank – the Federal Reserve – is the only bank in the U.S. allowed to issue bank notes. And these are used for currency. The Government’s Treasury pays all the Government’s bills. It pays the salaries of officials. It pays the debt service. It pays for the military etc. All with the bank notes issued by the Federal Reserve.

It acquires these bank notes in two ways. It collects taxes which are paid with these bank notes. And, when need arises, it solicits loans. It issues (sells) long term promissory notes called bonds. Bonds are promissory notes that need be repaid only many years after their sale. They are purchased by investors and the money paid for them – in bank notes – goes into the Treasury. The Treasury must pay the interest that is due each bondholder and it must eventually ‘redeem’ the bond. i.e. repay the loan that the bond represents. The bondholder buys the bond for its income (the interest payments) and because a U.S. Government Bond is considered to be an essentially risk free investment.

The Federal Reserve Bank buys these bonds on the open market with ‘bank notes’ i.e. with printed paper certificates called Federal Reserve notes. The idea: Every bank note issued is ‘backed’ by a valuable asset: a bond of the U.S. Government (assumed to be as good as gold!).

Click on the go/reset button in the Money Creation motion graphic above to see the process visually. In that graphic each column pair represents a balance sheet. Liquid assets are green. Illiquid assets are brown. Liabilities are red. And net worth is blue. See  http://chesters.org/marvin/economations/ for further elucidation.

The modern method of ‘printing money’ to pay its bills is this: The Government Treasury issues (i.e. sells) bonds which the Central Bank (the Fed) then buys with ‘bank notes’ that it prints. The law says that the government may not exceed the debt allowed by Congress. So the debt ceiling must be raised periodically to permit the Treasury to sell bonds in order to have money printed by the Federal Reserve to pay its debts.