Government Debt versus Private Debt

From: William F Hummel (wfhummel_at_comcast.net)
Date: 09/06/04 

Date: Mon, 06 Sep 2004 21:04:32 GMT

                         Government Debt versus Private Debt

To understand the difference between government debt and private debt,
we must first understand the distinct roles played by the monetary
base issued by the Federal Reserve and credit money issued by private
banks. This distinction is of little significance to the average
person, but it is of crucial importance to the banking system.

Why the Government Borrows

The public borrows from banks in order to acquire credit money to
spend on investment or consumption. In contrast, the government
borrows from the public only as needed to recapture its deficit
spending, all of which is base money. It does so to enable the Fed to
control the supply of reserves (base money) in the banking system, and
thereby control the short term interest rate. The ultimate objective
is to control the inflation rate over the long term.

When we adopted a monetary base of intrinsically worthless paper money
in the mid 20th century, we created a new paradigm that is widely
misunderstood even today. The imperatives are quite different from
those of the earlier gold-based system. Controlling the abundance of
base money is key to maintaining its purchasing power. It is up to
the Treasury and Fed, acting together, to do that. Government
borrowing plays an indispensable role.

Rolling Over Government Debt

Nothing about government debt in a fiat money system requires that it
be paid off. Individual securities must of course be redeemed as they
mature. But the Treasury can roll over its maturing debt
indefinitely. Rolling over means selling new securities to pay for
the redemption of maturing securities. Thus rolling over the debt is
not dependent on tax revenues.

Treasury securities offer an interest-earning alternative to the money
the government spends into circulation. When the private sector has
more non-interest-earning base money in the aggregate than it wishes
to hold, its only alternative is to buy Treasury securities. There
will always be willing buyers of Treasury securities because the
Treasury can pay whatever interest rate the market demands. The Fed
strongly influences the market rates on Treasury securities through
its selection and control of the Fed funds rate.

Interest Rates in Borrowing

It is often claimed that government borrowing is in competition with
private sector borrowing. That is incorrect. The government borrows
in base money while the private sector borrows in credit money.
Government borrowing has no net effect on the amount of base money
since its deficit spending matches its borrowing, on average.

The interest rates on short term Treasury securities and on credit
money are both a function of Fed monetary policy, and not a function
of each other. The notion that the interest rate on one directly
affects the other is to misunderstand the causal relation.

Government Debt as Perpetuities

Unfortunately conventional wisdom overlooks the fact that the debt can
be carried indefinitely at no financial risk to either the government
or the private sector. Individuals can become bankrupt with too much
borrowing, but the State can never become bankrupt if it borrows in
the same currency it issues.

Nearly everyone views government debt as a future tax liability of the
private sector. This is true only in theory. The unique position of
the State as issuer of the monetary base, enables it to roll over its
debt continuously. By electing to do so, its securities become the
functional equivalent of perpetuities, i.e. bonds that have no
maturity and thus are never redeemed. De facto, there is no net tax
liability on perpetuities.

Net Financial Wealth of the Private Sector

Treasury securities are valuable assets for the holders. They can be
sold for money or pledged as collateral for loans. Together with the
monetary base they comprise the net financial wealth of the private
sector. By contrast, bank lending does not affect the financial
wealth of the private sector because all such credit is matched by an
equal amount of borrower debt.

The value of the Treasury securities is not in the interest payments
they shed. Those payments are covered by tax revenues, and are
therefore a wash in the aggregate. The value is in the principal,
just as in the case of Federal Reserve notes. The public trades one
for the other, depending on degree of liquidity it desires at any
given time. If the public holds $X billion in Treasury securities and
$Y billion in notes, it has greater net financial wealth than if it
only holds $Y billion in notes.

The Upper Limit to Government Debt

Nevertheless it is incorrect to conclude that the larger the national
debt, the better. If the net financial wealth of the private sector
is allowed to grow too large, the penalty will be price inflation,
even though the amount of base money remains unchanged. This is the
so called "wealth effect" on consumer spending. But as long as the
debt is viewed as a savings vehicle by the private sector, it is
benign and a valuable asset for the nation.

The debt/GDP ratio reached an all-time high in World War II. Yet the
annualized inflation rate was only 2% during the 20 year period,
1949-1968, following the war. During the Reagan and Bush
administrations of 1981-1992, the inflation rate trended downward even
though the debt quadrupled. The evidence suggests that the
availability of credit money plays a far more important role in price
inflation than the net financial wealth of the private sector,
popularly known as the national debt.

William F Hummel

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