Sunday, October 6, 2013

Government Debt is NOT Money Supply?

Blogsphere frequently contains discussion of money and money supply, with the discussion then continuing into issues of bank deposits and national debt.  The common thread between these subjects is "the nature of loans".  This common thread is ill perceived, leading to chaotic discussion, with ultimate division into schools of thought, never to agree.

Before you jump to the next blog, please understand that a loan is more than an agreement that you understand well.  It has a life of it's own that needs to be built into models of the economy.

It is very common practice for customers to get loans.  Most common are loans for cars and loans for houses. If you have made a loan, you know all about loans. Right?  Well, did you know that the lender often sells that loan?  Did you know that the loan may be sold many times before you finally pay it off?  Did you consider that the loan had a life span?

Life span of a loan is a convenient way of economically describing a loan. A life has a beginning, a period of existence, and an end.  A loan can be viewed as having these three properties of continuum.  We will examine these properties in order.

Economist like tight definitions so here we will make some assumptions:

1.  The loan is denominated in money.
2.  The loan has a physical component that can could include a paper or electronic record.

A continuum has a beginning.  The beginning of a loan is agreement between two or more parties to trade money for action or property.  This action implies that:

1.  The lender has money to loan.  Large amounts of money are likely to take a long time to accumulate so the lender of large amounts of money must have a low propensity to spend money, allowing him to accumulate.   (Alternatively, the lender has a very large income, allowing him money flows far in excess of needs for daily living.)

2.  The borrower has a project or purchase in mind for immediate action.

3.  The borrower makes a commitment to return the money in the future.  This implies a time contract.  The initial value of the contract would be at least the value of the loan.

Following loan completion, we would expect several economic indicators to change:

1.  If a loan from a bank, bank deposits would rise in total.

2.  If a loan to government, money supply measures which included Federal Debt would rise.

3.  Unemployment would fall as the loaned money was used to complete a project or workers toiled to replace reduced inventory.

4.  If the loan was a continuation of a pattern (annual loans for equal amounts), unemployment would not change.

During the interval between loan beginning and loan close, the loan will exist as property. The borrower has an obligation that will be valuable when the money is returned. This results in an opportunity for trade between lenders, one who wants to sell an existing loan and another who wants to loan funds in waiting.  This sort of trade is ubiquitous.

Finally, at the end of the loan period, the money on loan is expected to be returned. This will result in a reversal of the economic indicators affected at loan beginning.

Expectation-of-economic-condition-reversal is a very important consideration.  It makes obvious that the use of loans by government to increase employment is doomed to short term success. A single step increase in employment purchased by loan funds can only be sustained by a similar loan the following period.  A second step increase in employment can only be purchased by an additional loan added to the first step loan, forcing subsequent period loans to be each higher.
A return to no-new-loan conditions by government would result in a two step decrease in employment, reversing the stimulus of the earlier loans.

With this background, we are ready to make a leap to discuss the subject of the post title, "Government Debt is NOT Money Supply?" .

We will begin the second half of this post by assuming that:

1.  The Federal Government pays employees with Federal Reserve Notes.

2.  The Federal Government gets the Federal Reserve Notes from the Federal Reserve in exchange for a contract to return the notes after a period.  This constitutes a loan from the Federal Reserve to the Federal Government, which will be evidenced by Federal Debt.

3.  Once the initial Federal Reserve Notes are issued to employees, owners of the notes can use Federal Reserve Notes to purchase Federal Debt.

Remembering our earlier discussion of loans, the Federal Reserve is the lender, the Federal Government the borrower.  The property borrowed is the Federal Reserve Notes.  The evidence of debt is the contract named Federal Debt.

Federal Reserve Notes are the money we carry in our wallets. Our bank deposits are denominated in Federal Reserve Notes.  It is very helpful to know how much money is available in the economy but it is very widely distributed, making it difficult to count.  On the other hand, if we recognize that all Federal Reserve Notes first come from the government (otherwise they would be counterfeit), then it is easy to equate Federal Reserve Notes with Federal Debt and know what the money supply is.

This seems simple but there is no-where near as many Federal Reserve Notes as there is Federal Debt.  Not close.  Why not and where might the difference lay?

The Federal Reserve is the first place to look.  The Federal Reserve has no money of its own to use for anything.  It can only print Federal Reserve Notes.  Federal Reserve Notes are used to purchase Federal Debt and, more recently, Mortgage Backed Securities.  We then can add the Federal Debt and Mortgage Backed Securities total of the Federal Reserve to know how many Federal Reserve Notes are in supply?  No, there is a way that the supply of Federal Reserve Notes is reduced relative to  Federal Debt.

The Federal Government, having no money of its own, gets money from the Federal Reserve first, then from the public once the public has money to spend. The non-taxed spending by the Federal Government mostly comes from loans sold to the public.  This borrowing uses the same Federal Reserve Notes time after time in the form of roll-over loans.  The number of Federal Reserve Notes does not change greatly, but the total amount of Federal Debt increases annually.

From the standpoint of the public, the amount of money available increases as fast as the Federal Debt increases.

Is it correct to say that the money is invested in Federal Debt so that the money is not available?  Yes and No.  Yes, the money is not available for a short time.  No, the money is available in entirety if we are willing to wait to the end of the debt period.  Further, from our discussion on loans, we know the money is available at anytime if a trade of contract for money can be made.

To this blogger, the knowledge that Federal Debt will be available as Federal Reserve Notes (money) at debt-term-end, is convincing argument that Federal Debt is an excellent measure of money supply.  Knowledge that Federal Debt is convertible to money upon very short notice is a reinforcing argument.  This readily available measure of money supply should be used more often in "money supply" context.

(Bank loans also add to money supply. Further discussion on this topic can be found at Government Provided Money Supply.)

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