How deficit spending affects the money supply

[William Hummel]

1. When government spends more than it receives in taxes (deficit spends), the result is an increase of money in the private sector.

2. However the Treasury recaptures that amount of money on average by selling securities in the open market in order to maintain the balance in its general fund.

 3. Thus the private sector gains in net financial wealth in the form of securities when the government deficit spends.  In effect, the government pays for its deficit spending with securities rather than money.  

4. Now if the demand for bank loans increases, as indicated by a rising Fed funds rate, the Fed will purchase securities in the open market as needed to maintain control of that rate.

5. That converts securities into money without affecting net financial wealth, and increases the direct purchasing power (money) of the private sector.

6. An interesting question then is what would cause government deficit spending to increase the demand for bank loans?

William

[George Chandler]

How does the the interest charge on the debt fit in to this?

[William Hummel]

Interest paid on the debt is a line item in budget and is simply a part of the spending.

[Mark Bachmann]

William,

 

Your 'interesting question' is obviously a key one right now.  To me, the answer seems to be that deficit spending per se does nothing to increase the demand for bank loans or to stimulate the economy.   As others have suggested here, the nature of the spending matters a great deal and determines the difference between stimulation and dead weight. True investment spending - e.g., for needed infrastructure, focused research, focused job training, restorative health care -  should open up new economic channels and result in the growth of healthy loan demand if the private sector is vibrant. Other spending - for useless infrastructure or poorly administered social programs - generally will not.

 

On a side note, with respect to social spending, this is not an argument against it, but rather a belief statement that it should mostly be justified on moral rather than economic grounds.

 

     Mark Bachmann

[Joe Leote]

When Banks that are "too big to fail," or the Bank sector as a whole, must take accounting charges on loan defaults that deplete bank capital, then Nonbanks are reluctant to put new capital into banks.

Government spending helps re-capitalize and stabilize the bank sector in such a system. Deficit spending and Fed QE keeps cash flowing to prevent more systemic defaults and avoid a great depression.

Joe

[Hugo Heden]

I agree with both Mark and Joe below. 

The way I read Mark is: Deficit spending can, if done properly, stimulate the economy by means of job creation and such. 

The effect should be present even if the deficits take the form of securities rather than money -- it is not of of much importance. (Not sure that everyone would agree with that though? Albeit not exactly like money, securities are actually highly liquid assets that can easily be sold -- or used as collateral for taking on a new loan.

This should indirectly -- over time -- increase demand for new bank loans for say business investment, as businesses meet increasing demand. 

The way I read Joe is: Government deficit spending can help recapitalize an over-leveraged and under-capitalized private sector, notably the financial sector. This enables banks to issue more loans -- i.e it increases the supply of possible loans to be made. (Yes, Williams question was about demand rather than supply of bank loans, but it is still a good point.)

- Hugo

 

[William Hummel]

Mark,

 

I agree that government deficit spending per se does nothing for economy. So let's consider the effect of an increase in deficit spending. That would obviously increase net financial wealth faster. Would it also increase real output and reduce unemployment. I think the answer is yes IF the economy is operating well below its potential with a significant fraction unemployed, as is currently the case. However the degree of improvement depends on how the deficit is increased.

 

The deficit could be increased with either a reduction in taxes or with an increase in spending. In the near term, a reduction in taxes benefits only those already working, and mainly those who are consumers. There is no shortage of financial wealth seeking good investments, so I would discount the benefit of reduced taxes to entrepreneurs and most existing firms. Increased spending, if used in the way you suggested, has the benefit of directly increasing employment as well as improving the infrastructure for the long term. However if the private sector can do the job, government should issue contracts to private firms rather hiring employees and managing the programs themselves. 

 

William 

 

----- Original Message -----

From: Mark Bachmann

To: understan...@googlegroups.com

Sent: Wednesday, May 01, 2013 11:24 AM

Subject: Re: How deficit spending affects the money supply

[John Hermann]

It is not true to say that all securities are highly liquid.  Thus long term bonds would not be regarded as highly liquid.  Bank liquidity is usually defined as the conjunction of accessible reserves (currency on hand plus CB deposits) and short term government securities.    John

[William Hummel]

From: Hugo Heden

Sent: Wednesday, May 01, 2013 2:15 PM

Subject: Re: How deficit spending affects the money supply

I agree with both Mark and Joe below. 

The way I read Mark is: Deficit spending can, if done properly, stimulate the economy by means of job creation and such. 

The effect should be present even if the deficits take the form of securities rather than money -- it is not of of much importance. (Not sure that everyone would agree with that though? Albeit not exactly like money, securities are actually highly liquid assets that can easily be sold -- or used as collateral for taking on a new loan.

 

Hugo

 

One might be able to buy some specific thing in exchange for a Treasury security, but to be useful as a medium of exchange, i.e. money, it must be widely accepted as a means of payment. In a fractional reserve system, a Treasury security could be used as collateral to back a loan from a bank. That would indeed increase the money supply. However in a full reserve system, credit money does not exist. Money is exclusively created by the central bank and it is all fiat money. One could exchange a Treasury security for money from a bank, but that would not increase the money supply.

 

William

 

[Jean Erick]

     The answer is long term, not short term.  There is no magic bullet.  Long term:  infrastructure, education, tax reform to put it back where it started, tax unproductive making of money, produce some limit to the amount of debt relative to GDP.  The thing is, it is not just economic.  The essential conomic is political.  Democracy, freedom is the allowance of creative thought.  We have become to fascist.  To corporate.

     The essential element of "economics" that we need is freedom.

 

      To put it another way, it appears that the oligarchal, kingship type entity mechansim of the distribution of decision making power, via its money, has impinged to greatly upon the democratic political mechanism of the distribution of decision making power, and this is tending to stifle the economy.

 

or

 

     Great progress has been made in 3rd world development.  But the common practice of giving free rein to business and banks to faciliate such great

ventures has resulted in a stopping of economic activity, not unusual.  We need to regroup, fend off the oligarchy, sustain ourselves while using a calmer, Jeffrey Sachs type approach and end world poverty, a goal historically unavailable to us but now well within our grasp.

 

James