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CNBC: It's a Debt Ceiling not a Spending Ceiling

So what happens when the government writes checks on an account with no money? Nothing out of the ordinary. Those checks will all clear, with deposits made in the recipients' bank accounts just as they would have if the account was not underfunded.

Let's use an example to explain this. Let's say you are a retiree who collects Social Security payments. When the check comes, you take it to your bank for deposit. The bank submits the check to the Federal Reserve for clearing. The Federal Reserve clears the check by crediting the bank with a deposit in the amount of the check. The bank then credits your account with that amount.

Notice that money has gone into your bank account but it hasn't come out of any other account. If the government has enough money in its account with the Federal Reserve, the Fed could debit that account.

But if the government doesn't have enough money in the account, the Fed just doesn't debit anything at all. It simply creates the credit in the account without a counter-balancing debit anywhere else.

The government is unlike a household because it has the ability to create money simply by creating deposits. This money creation ability means that the government does not need to have raised funds--through taxes or borrowing--before it spends them.

Now, of course, our Federal Reserve is supposed to be independent. In theory, at least, it is possible the Fed could decline to credit accounts with deposits from the empty account of the US Treasury. But it is obliged by law to adopt policies that maximize employment and price stability. Refusing to honor the U.S. Treasury's checks would hardly seem likely to promote fuller employment and price stability.

Having the Treasury spend regardless of the emptiness of its bank account is not really so different from the way monetary policy is ordinarily conducted. Think about the spectacular growth of the balance sheet of the Federal Reserve during the financial crisis and recession. How was it that the Fed could afford to buy all those bonds it purchased during the two rounds of quantitative easing?

The answer is that in a system of fiat money, the Fed can afford anything it wants so long as the sellers are willing to accept dollars. If the Fed decides to buy a bond, it can simply credit the account of the bank from which it bought the bond. This expands the money supply by the amount equal to the purchase price of the bond.

"The future is already here -- it's just not very evenly distributed" William Gibson
by ChrisCook (cojockathotmaildotcom) on Fri Jul 29th, 2011 at 06:48:52 PM EST


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