Does the Fed Understand the Solvency Constraint?

Really interesting piece out of the St Louis Fed from last year that shows they might know more than they let on at times.  They say:

“As the sole manufacturer of dollars, whose debt is denominated in dollars, the U.S. government can never become insolvent, i.e., unable to pay its bills.6 In this sense, the government is not dependent on credit markets to remain operational. Moreover, there will always be a market for U.S. government debt at home because the U.S. government has the only means of creating risk-free dollar-denominated assets (by virtue of never facing insolvency and paying interest rates over the inflation rate, e.g., TIPS—Treasury Inflation-Protected Securities). Together with the unusually high, but manageable, level of the current debt, these facts imply that the current U.S. government can wait out any short-term economic developments until long-run growth is restored.7 Further, without an immediate need to drastically reduce the debt, the mechanism between high debt and slow growth loses most of its credibility.”

There’s a few things wrong in here, but all in all it’s a good description of the USA’s situation and a huge step in the right direction.   First of all, the government is not the “sole manufacturer of dollars”.  Almost all of the money in the USA is created by the private competitive banking system.  Ie, the issuance of money has been privatized in the USA.  The banks create inside money (deposits – the vast majority of money) and the government creates outside money (notes, coins and reserves – the minority of the money supply).  We have a market based monetary system in the USA which is dominated by an oligopoly of private companies.  It’s not perfect by any means, but it’s certainly better than the rogue banking system we had in the 1800s.  Unfortunately, some of the deregulatory steps in the last 30 years have made us a bit more rogue which has obviously had some negative effects….

Also, the current design does require the government to procure funds – the government is never free from the constraint that it is a user of the social construct (just like the rest of us).  The government cannot control quantity value so it’s not unusual for the government to be unable to obtain funding from the private sector (as is the case in a hyperinflation when the tax system and bond markets collapse).  When we understand the institutional design of the monetary system we can see that the Treasury is a user of money by design.  The banks issue money and the Treasury procures funds.  This has essentially created a market based money system where the creation of new money is the result of a market based system overseen by private competitive profit seeking entities.  So the government must be able to procure funds via taxes and bonds in order to be able to spend.

Of course, the government doesn’t have a problem procuring funds so long as output is strong and demand for the currency is strong.  Also, the bond market is designed in such a manner that the Primary Dealers are required to bid at auctions and are happy to do so as long as it remains profitable for them to do business with the US government and inflation remains moderately low (which is just about 99% of the time).  Of course, it’s that 1% of the time that kills 100% of the money supply.  It’s not unimaginable that, in a hyperinflation, the PD’s would not bid as it becomes unprofitable and they become survive first, do government bidding second, entities.  It’s likely that the tax system would also be collapsing in such a scenario as is generally the case in a hyperinflation so this would exacerbate the procurement process here.

In such a scenario the government would fund itself by using its central bank and the currency death spiral would be well in motion.  But this is an extreme example and not one the USA has to worry about since currency demand is primarily a function of output (quantity value) and with 25% of the world’s output the risk of hyperinflation in the USA remains extraordinarily low as I’ve long been saying.

But hey, this looks like progress.  It’s not perfect, but it’s certainly better than the constant nonsense we hear from the mainstream about how the USA is on the verge of default or some Greek-like scenario.  The real constraint in the USA is not running out of money, but inflation….

H/T: Mosler Economics