Real dollars and funny money

J.D. Alt

I keep trying to unravel the confusion knotted beneath the surface of our public discourse about money.

For example, it seems evident that most people believe that U.S. Dollars are “created” by business entrepreneurs making profits. Until this happens, the understanding seems to be, the number of dollars available for everyone to try to get some share of is like a big lake of money we’re all drinking from, with the biggest drinker of all being the U.S. government. What we seem to mean by “economic growth” is this lake growing bigger, and we’re constantly measuring it’s depth and volume in terms of something we call “Gross Domestic Product”. The process that makes the money-lake grow is an entrepreneur investing some of the existing dollars in some venture, and then making a profit on that investment thereby creating new dollars that didn’t exist before, which increases the overall size of the lake. Dollars created in this way are “real” dollars because they are created by private business entrepreneurs competing in a free market. The federal government (for some mysterious and perverse reason that we can’t entirely explain) has the authority to “print” dollars any time it sees the need, but dollars created in this fashion are “funny money”- that is, they simply dilute the value of the “real” dollars and enable the federal government to spend money it doesn’t really have. To protect the “soundness” of our lake of money, we should therefore limit – at all costs – the federal government’s “printing” of dollars, and the most effective way to achieve this goal is to require the federal government to borrow dollars from the bond market if, in fact, it has to spend more dollars than it collects in taxes. Having imposed this requirement, we must then carefully track the number of dollars the federal government borrows because if that number exceeds a certain percentage of our Gross Domestic Product, we can assume the government will never be able to repay the debt (because the taxes available from GDP are mathematically inadequate) at which point the federal government will be insolvent. When we reach the point that the federal government is borrowing too many dollars (and, therefore, approaching insolvency) we have to either raise taxes or reduce government spending. If we raise taxes—especially on the entrepreneurs and businessmen—that will reduce the incentive to invest and create jobs, and will slow the process by which new “real” money is created, causing economic growth to falter. The best course of action to reduce an overly large federal debt, therefore, is to reduce federal spending. On its surface, this seems a perfectly reasonable narrative, even though it is politically difficult to translate into action (as we are currently observing).

Beneath the surface however, if you feel around, you’ll discover some knotty problems with the underlying logic. The first is the basic premise that “new” money is created when a businessman sells goods or services for a profit. By simple accounting, this cannot be true because the businessman’s profit is a debit on the balance sheet of whoever bought his goods and services. No “new” money is created at all, it’s just moved from one place to another. So if we achieve the “economic growth” we’re always talking about, how does the “new” money get created that corresponds to that growth?

One answer that often pops out in the confusion of our national dialog is that “new” money gets created when an entrepreneur takes out a bank loan to finance a business venture. When the loan is executed, the bank deposits, say, $1000 in the entrepreneur’s bank account. Where did those dollars come from? Once upon a time we imagined those were depositor’s dollars the bank was lending, but now we’ve gotten sophisticated and allowed ourselves to accept the odd reality that banks loan out way more dollars than they have on deposit. So when the bank executes the loan to the entrepreneur, it doesn’t remove dollars from the accounts of its depositor’s and deposit them in the entrepreneur’s account – instead it simply makes an electronic deposit in the entrepreneur’s account by using computer keystrokes. These dollars, then, created by the bank’s computer keystrokes, must be the “new” dollars that get poured into the lake. Before the loan was issued, they didn’t exist, and in the issuing of them, they are not subtracted from someone else’s account or balance sheet. They are completely new! The entrepreneur then spends them, buying goods and services to implement his business venture; he might even hire some new employees and pay their wages and salaries using the new dollars – and by this process the new “real” dollars are pushed into the economy.

Except there’s a problem with this explanation as well. Again, it’s a simple balance sheet issue: When the entrepreneur repays the $1000 loan to the bank, the “new” money the loan created is erased. The number of dollars in the money-lake is now exactly the same as before the loan was made and repaid. We assume the entrepreneur made a profit with his venture, and part of this profit he will have paid to the bank as interest on the loan—but since we now understand that the profit is a debit on the balance sheet of the customer who bought the entrepreneur’s goods or services, we can see that interest dollars the bank earns comes from the customer as well, and are not “new” money either.

In fact, no matter how many transactions we can imagine between banks and entrepreneurs and customers, we cannot create any “new” net dollars, but only move existing dollars from place to place, from one side of some balance sheet over here to the other side of another balance sheet over there. While this process doesn’t add to the net financial assets in the private economy, it very usefully does create a whole lot of something else: it creates the real goods and services the entrepreneurs and businesses and working people produce by virtue of that money being exchanged from one balance sheet to another: cars and bridges and pizzas and roof-repairs and medicines and high-school educations (the complete list is quite long).

But this just brings us back to the original knot we were trying to untangle, namely: It’s pretty obvious that as we create more and more of these real goods and services, we’re going to need more and more dollars in our money- lake – otherwise, one of two things will occur: (a) the dollar value of everything we own will begin to fall precipitously (deflation) because the same number of dollars has to be allocated to more and more stuff; or (b) we’ll have to begin producing fewer real goods and services to keep prices aligned with the amount of money in the lake. This is called “shooting yourself in the foot,” although it would be more accurate to infer the aim is directed higher.

Where in the world do the “new” dollars come from then? The answer everyone is just going to have to grit their teeth and accept is, unfortunately, “funny money”. There’s only one place that U.S. Dollars – new or old – originate from: the sovereign U.S. government “prints” them, either on paper or, more often than not today, electronically with computer keystrokes. Wait a minute, you are saying, that sounds a lot like what the bank was doing when it made a loan, right? Keystroke a deposit into some entrepreneur’s account. Except there’s a fundamental difference between the U.S. government’s keystrokes and the bank’s keystrokes (I can feel the knot starting to loosen here….).

The bank’s keystrokes created dollars that had to be repaid to the bank – – which, when that occurred, effectively erased the keystrokes. The U.S. government’s keystrokes, in contrast, create dollars that don’t have to be repaid – ever. For example, let’s imagine Marble Monument Repair sends the U.S. government a bill for $1000 for services it provided patching up the Lincoln Memorial. Someone in the U.S. government makes some keystrokes and $1000 appears in Marble Monument Repair’s bank account. Does Marble Monument Repair have to repay those dollars? Obviously not. Are those then completely new dollars that have been inserted into the private sector economy? I believe they are. Should we be calling them “funny money”? Will they dilute the value of the “real” dollars in our money-lake? I believe that as long as there are real resources available to put those Dollars to work (in this case, marble repair materials, tools, and labor) our money lake will not be diluted but, instead, will be expanded—undoing exactly the knot we were struggling with.

What is “funny”, though, is the peculiar fact that it is likely this $1000 payment to Marble Monument Repair will be added to what we call our nation’s “deficit”- and that we feel obligated, for some fearful reason, to require our sovereign government to borrow $1000 to make up for that “deficit”. By this convoluted logic, we take a useful instance of sovereign spending (Lincoln is patched and the economy grown) and transform it into national debt – which we then flail ourselves with until the blood flows. This is the biggest knot of all.

J.D. Alt is an architect and author, and a regular contributor to New Economic Perspectives. Recent books include 2020 and The architect who couldn’t sing.

Source: http://neweconomicperspectives.org/2013/02/real-dollars-and-funny-money.html#comment-133435