Analogies never prove anything, However let me use this one to illustrate this one.
The question I want to ask is ---
How much difference does it make if the US Gov. sells bonds after the fact to pay for deficit spending compared to just creating dollars and spending them? I'm assuming here that there is no crisis, just the normal every day situation.
I will use a game of Monopoly(c) to illustrate my argument. I will make a few rule changes though.
1] At the start each player gets $1000 in cash and five $100 bonds.
2] Each time you go past GO you get $2 in interest for each bond you hold.
3] The Bank or a separate bank will buy your bonds during your turn for a discount of $1, so you get $99. During your turn it will sell you a bond for $99.
These rules are intended to replace the *fact* that you can sell a US Bond at most any time and there is always going to be a willing buyer for it if there is a small discount. That is, US Gov. Bonds are very liquid. If this is not the case please tell me I'm wrong about this.
Now, I ask you, are these rules going to make any difference in how the game is played?
I assert that they change things very, very little. Players can park their money in Bonds to try to earn a little more money when they go around GO. If they land on a good property to buy or one owned by another player then [still in their turn] sell a bond to get the money they need to buy it or to pay the rent.
. . .The same thing happens every day IRL. People and corps. with Bonds can sell them if they want cash to buy something or to pay a bill. Currently, the world is awash in dollars, there is IIRC about $5T in cash and IIRC about $17T in debt (not owed to the US , like SS Trust Fund). There is also $XT in bank deposits created by loans. Therefore, there is plenty of money around for someone who wants to sell his US Gov. Bond (to do that if he wants to) to be able to do that.
This is the answer that I got.
When the government matches an increase in its deficit spending with debt issued to the non-government sector, the immediate stimulus to aggregate expenditure is less than would be the case if the government didn’t borrow at all.
The answer is False.
Note the use of the term ‘immediate’, which is included so that you ignore any income flows that subsequently flow from any debt issued.
The mainstream macroeconomic textbooks all have a chapter on fiscal policy (and it is often written in the context of the so-called IS-LM model but not always).
The chapters always introduces the so-called Government Budget Constraint that alleges that governments have to “finance” all spending either through taxation; debt-issuance; or money creation. The writer fails to understand that government spending is performed in the same way irrespective of the accompanying monetary operations.
The textbook argument claims that money creation (borrowing from central bank) is inflationary while the latter (private bond sales) is less so. These conclusions are based on their erroneous claim that “money creation” adds more to aggregate demand than bond sales, because the latter forces up interest rates which crowd out some private spending.
All these claims are without foundation in a fiat monetary system and an understanding of the banking operations that occur when governments spend and issue debt helps to show why.
So what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a fiscal deficit without issuing debt?
Like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.
The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made.
Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet).
Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.
This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management. The aim of the central bank is to “hit” a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.
When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target.
Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.
There is no sense that these debt sales have anything to do with “financing” government net spending. The sales are a monetary operation aimed at interest-rate maintenance.
So M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. It is this result that leads to the conclusion that that deficits increase net financial assets in the non-government sector.
What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.
The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).
There is no difference to the impact of the deficits on net worth in the non-government sector.
Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.
However, the reality is that:
1] Building bank reserves does not increase the ability of the banks to lend.
The money multiplier process so loved by the mainstream does not describe the way in which banks make loans.
2] Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.
3] So the banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.
This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.
It is totally fallacious to think that private placement [does he mean 'creation'?] of debt reduces the inflation risk. It does not.
Link = http://bilbo.economicoutlook.net/blog/?p=40049