Rarely Asked Questions: How Does Government Pay Its Bills?

Winner of my "Best Visual Illustration of Rarely Asked Questions" contest, via EntheoNation.

I'm crazy about the Biden proposals introduced in Wednesday's Joint Speech, or as Susan Glasser/New Yorker says, in what seems to me like the most accurate summary I've seen,

To anyone who remembered last year’s Democratic primaries, the President’s first address to a joint session of Congress sounded as if Elizabeth Warren, and not Biden, had won.

and I'm going to want to take issue with scoffers, not necessarily representing "Modern Monetary Theory", including the generally very estimable David Dayen at The American Prospect, complaining of "that old deficit hawkery" in the way the plan is being sold.

I don't think it's that at all. But before I get there, I'd like to lay down some basics on the nature of government spending in a modern state that I think aren't well understood. because most of us think we already know, and as I've been learning recently we don't:

Rarely Asked Questions:

Q: How does the government pay its bills?

A: It has a checking account, known as the Fund Balance With Treasury (FBWT).

Q: Where does the money come from?

A: Everyplace that gives the US government money, including tax collections by the IRS and other agencies, fees it collects from various enterprises (think parking at national parks. but there's lots more), and of course money it has borrowed from the private sector by selling bonds and other kinds of federal paper. Unlike your checking account, it also includes all the assets the government owns that it can't easily convert into cash, generally inventory, and isn't supposed to sell, like stocks of toilet paper and paperclips and nuclear weapons and land, plus the loans it issues to veterans, students, small business owners, etc.

Q: So that's a lot of money, right?

A: Well, also unlike your checking account, it also lists all the government's liabilities: the money it has promised to pay for various purposes, including paying for programs according to Congressional appropriations, or paying interest on those bonds. A lot of the money is reserved for one purpose or another by Congressional demand and can only be spent on the specific purpose intended. Only a restricted part is available for whatever comes up, in a General Fund, and probably a lot less than illustrated in this more humble example from some kind of local government supplied by the Governmental Accounting Standards Board:

In federal practice, the whole thing, including the General Fund, can run out pretty fast, as we've seen in the various government shutdowns engineered by Republicans in recent years.

When the payment officers cut a check to a government agency's account for the agency's spending needs, or nowadays more likely electronically credit the account, they must electronically debit the place in the FBWT they found the money in, whether that is reserved for the specific use or the General Fund. If they can't do that, they can't cut the check. But in general they can, and do, issue the payment to the agency, with a note clarifying the authority it was issued under—because the money may be tax money or loan money, but it's generally there when it's needed.

Q: Then how come famous heterodox economics professor and Bernie Sanders adviser Stephanie Kelton continually says things like,

all government spending is paid for in one way and one way only—the Federal Reserve credits the appropriate bank accounts...

A: The correct answer is, I really don't know how come she says it.

Q: I mean, what does the Federal Reserve have to do with it? And also, why does she mention the crediting but not the debiting?

A: I can't say. You'd certainly think she'd have a clearer idea of how it works, after her turn as an economic adviser to the Senate Budget Committees's Democrats (Ranking Member, Bernard Sanders, I-VT) for over a year in 2015-16.  But she doesn't seem to have any idea whatever. Probably I don't know what the job of an economics adviser to the Senate Budget Committee entails.

But in point of fact no government spending is paid for by the Federal Reserve crediting a departmental bank account. Indeed, it's the Treasury that pays the Fed, for operating expenses, as appropriated by Congress, four or five billion dollars a year.

The Fed never issues money to any government department, except once a year, not in fiat money but earned income, when it sends the General Fund a check representing its surplus for the year ($86.89 billion in 2020, way up from $55.5 billion in 2019, as they bought huge quantities of bonds and mortgage-backed securities in the hope of stabilizing the markets in the wave of the pandemic and then of course collected interest on them throughout the year), because it's a nonprofit institution, so it is required to give its profits to us, to our national checking account, the FBWT.

And every dime of checks cut by Treasury is accounted for in terms of Treasury income, taxes, fees, and borrowed money.

Q: But you said the Fed can create money out of thin air! 

A: Can and does, tons and tons of it, in fact, but not because it's the federal government; it's because it's not the federal government. It's really a nonprofit bank, owned but not run by Congress, open to the opportunities presented by the fractional reserve banking system, and able to create money by issuing a loan; the Fed issues unsupported credits to the banks under its wing, in its Open Market Operations, in return for government bonds, but with the understanding that the bank isn't going to spend any of the money; they're going to use it as collateral to put out their own loans; it remains in their reserve accounts. That's what the Fed does it for, to beef up the mount of money circulating when it's lending, and shrink it when it's in the opposite phase. The Federal Reserve can create money out of thin air, but only for the use of private institutions, and only in the expectation that the money is not going to be spent.

Q: But that's just the accounting rules, right? Wouldn't it be possible, at least in theory, for Congress to change the rules? They have the authority to issue currency, right? Why couldn't they be authorized to send the FBWT a note: "Please credit the General Fund with $500 billion new dollars that didn't exist because Congress says you can."

A: They absolutely could! It would be a different system, but that's not to say it wouldn't function, and it wouldn't necessarily lead to Zimbabwe craziness either. For instance, as I've shown elsewhere, it could also lead to decades of quiet despair, as in the old Soviet Union. 

I can even think of an occasion when an arrangement like that worked extremely well, when the Lincoln administration instituted the greenback dollar, a piece of paper with a promise from the government to pay the bearer on demand in gold that didn't exactly exist, as a way of financing the Civil War.

But the greenback, too, involved the creation of debt. That was really the whole point; the purpose of the currency was to give people, especially wealthy people, a way of buying war bonds, when money (in the form of gold or banknotes issued by private banks) was tight, as well as paying property taxes and the new (and probably unconstitutional, before the 16th Amendment) income tax, and the trick was that the government would pay the interest on the bonds in gold, collected through import taxes (which was required to be paid in gold). So effectively, the most important greenbacks, the ones Mr. Rich Investor plowed into the war effort, really were backed, very strongly.

So while the Confederacy printed money in Zimbabwe style, sparking inflation rising from 12% at the end of 1861 to over 9,000% by the end of the war, the Union, with its currency tied to the creation of a profitable debt, was able to hold inflation down to a bearable 80%, and quickly cut it back when the war was over by cutting down the supply of currency. "Printing money" was fantastic when it was tied to the contracting of a debt and limited by an end date (even though they didn't know when the war would end, they knew it would end).

Also, just because I love the radical Republicans of the 1860s so much, I'll beg you to note that the income tax was used precisely because it could be made steeply progressive, as Thaddeus Stevens said of the 1862 version:

While the rich and the thrifty will be obliged to contribute largely from the abundance of their means . . . no burdens have been imposed on the industrious laborer and mechanic . . . The food of the poor is untaxed; and no one will be affected by the provisions of this bill whose living depends solely on his manual labor.

In the next installment, when and if I get to it, I'll try to show how Lincolnesque, and radical, Biden's proposals are, deficit coverage and all.