Understanding Government Liabilities

I keep running into a strange issue in macroeconomic discussions – no one seems to agree on how we should account for government liabilities. For instance, Gold standard economists believe government issued cash is not a liability (even though the Federal Reserve specifically shows it as a liability on their balance sheet). MMT economists say government “debt” is an IOU, but not borrowed debt. They also, at times, refer to government debt as equity.¹ Other people think the government’s debt needs to be repaid. Other people think it’s some sort of debilitating liability, as if there isn’t an asset side of the equation that balances out. There’s even a whole new monetary movement designed to argue for “debt free money”. Anyhow, I want to try to explain this in a simple way that hopefully clears up some of the confusion. Let’s get into it.

Governments are Just Great Big HOAs. 

My favorite way to think of government and government liabilities is to use the simplest of all small governments – Home Owners Associations (HOAs). HOAs are small groups of homeowners that band together to establish a certain set of rules or services that they want to apply to a certain neighborhood of houses to establish some greater public good. So, you have a bunch of asset owners who presumably go out doing productive things for work and they essentially leverage their assets together and pool them into forming the HOA that helps them achieve some sort of social benefit for all the homeowners. Now, let’s say our make-believe HOA is the only society in the world and they want to create a payment system to help service the monetary needs of their members. They agree on a currency and agree to allow 5 members to create banks. These banks operate as stewards of the monetary system by making loans to homeowners who meet certain standards that make them reliable borrowers. These loans will create deposits which serve as the primary money in our system.

Now, let’s also say that the HOA wants to establish a court to enforce the rules that they’ve established and they hire 10 members to operate as employees of the HOA. They are able to “fund” this expansion of their HOA by taxing the existing deposits that have been created. Now, keep in mind, they don’t need to tax to get money. After all, they have the authority to print money for public purpose. But the alternative to taxing would be creating new financial assets that might cause some inflation in their economy. And if they decided to do that they could finance this balance sheet expansion in several ways:

1. They could print physical cash.
2. They could distribute electronic cash.
3. They could sell bonds in exchange for some amount of existing deposits.

From the most basic accounting perspective, all of this is asset and liability creation. It’s just record keeping, book keeping. And the basic reality of double entry book keeping is that balance sheets balance to keep the records orderly. So, when financial assets are created there are corresponding financial liabilities (and yes, cash is properly accounted for as a financial asset/liability). Regardless of taxonomy, there are assets (left hand stuff) and right hand stuff (equity and liabilities) that cancel out in either case. Importantly, the only time we create NET ASSETS is when we create non-financial assets. For instance, when one of our homeowners builds a house from nothing with no debt then that house stands as a net asset for our society.

This concept might seem overly confusing when you add in state governments, Central Banks and all that, but you can see that, from the perspective of our HOA, the accounting is quite simple.² Our members form the HOA. They fund that HOA by leveraging their collective wealth into public purpose. And they are collectively responsible for the negative and positive impacts that their HOA and its balance sheet might cause. Importantly, it should be obvious that every single member of the HOA is ultimately liable for what their HOA does when they expand their own balance sheet. After all, the HOA can cause rampant inflation if they were to go wild adding employees who do nothing in exchange for physical money that has been printed. In this sense, every single member of the HOA is liable for the liabilities that are created even though it won’t appear on their individual balance sheets.

On the other hand, long time readers will also understand that the HOA does not have to repay its debts. In fact, it’s more likely that its aggregate debts will expand over time as the neighborhood grows and its operations become more complex because it needs to service more needs. Aggregated balance sheets never actually get paid down in the long-run because we are constantly expanding assets and liabilities to grow the economy and service its ever expanding complexities. For instance, this chart of total sector debts in the USA will pretty much always keep going up because our aggregated economic entities are always borrowing more to create more non-financial assets over time. The rate of change might change at times and there’s even good arguments that certain sectors need to decompress in the short-term, but in the long-term that chart will pretty much always go up and to the right because we need the assets to service the various contractual obligations that help us get shit done.

What About the “Liable” Part? 

Wait, back up Señor Roche. What, specifically, is the government “liable” for if it doesn’t repay debt? Good question! At the most basic sense, the government is liable for something extremely important:

1. Being a good steward of the financial liabilities they issue so they don’t cause damaging inflation. 

You could argue that the government is liable for other, simpler responsibilities like interest payments, maintaining currency parity or helping regulate and manage the payment system, but at the end of the day the government is responsible for performing some public purpose while also being mindful of its potential to cause damaging inflation because that inflation can ultimately hurt everyone who formed the HOA and agreed to its use in the first place.

The way that the government chooses to finance its spending is unimportant in this matter. Cash is absolutely a liability of the government because we are all ultimately liable for its potential to cause inflation. The same basic fact is true of electronic deposits or bonds. We call these government liabilities different things (like reserves, cash, bonds, etc), but they’re all ultimately liabilities that the the government is responsible for being a good steward over.

Additionally, the fact that government cash, reserves, deposits or bonds, are liabilities, does not mean they are necessarily bad. There is often a negative connotation with the idea of a “liability”, but there is nothing inherently good or evil about assets and liabilities. When the government prints money to regulate the rules on our HOA that creates an asset for someone and also an aggregate liability for the HOA. This could be a good thing if it helps to better regulate and maintain our society so that people behave better. And it could also be bad if the rules don’t help and the printed money causes inflation. But the cause/effect is very complex so the expansion of new debt, whether public or private depends on many factors. We shouldn’t just always assume that more debt is bad. In fact, when it’s used wisely, debt can be extremely good. This is as true for a government as it is for a corporation or household.

Anyhow, that’s my simple view on all of this. I hope you find it a little bit helpful about a topic that many people seem to over-complicate in my opinion.

¹ – In fairness to MMT advocates, they hold so many conflicting views on matters like this that it’s understandable that they have trouble keeping them all straight. 

² – Central Banks are the cause of most of the confusion on this topic. At their most basic essence, CBs are just clearinghouses for interbank payments. Their liabilities are clearing assets for banks.