Why Do Sovereigns Borrow Bank Money?

by J.D. Alt, New Economic Perspectives

Why do so many people-including the authors of most economics textbooks-believe the U.S. banking system creates the U.S. dollars we earn and spend and pay our taxes with? It’s because the U.S. banking system does, in fact, “issue” the great majority of the dollars we use-by making loans to businesses and citizens which are not backed by “real” dollars the banks have on deposit. What everyone overlooks, however (for reasons not entirely clear) is the fact that these new loan dollars are “made real” by the U.S. government’s solemn promise to convert them at any time, on demand, into actual, “real”, sovereign U.S. dollars. The U.S. government is able to make this promise because, by law, it can issue the necessary actual dollars by fiat (by simply “declaring” the dollars into existence.) A lot of people (again for reasons not entirely clear) don’t like to hear that last part. But it’s simply a fact of life: the cash dollar bills you get from an ATM machine are not printed up (created) by the banks-they are printed (or created electronically as needed) ONLY by the U.S. sovereign government.

This seamless transmutation of bank dollars into U.S. sovereign dollars has the unfortunate side-effect of hiding the real distinction between the two kinds of money-a distinction (I think) I’m now starting to get a handle on: Bank dollars are created specifically to facilitate the production and exchange of private goods and services. Sovereign dollars, in contrast, are created to facilitate the production of collective goods and services-and, furthermore, one of the PRIMARY collective goods the sovereign dollars create is the private banking system itself (which, as we have just noted, is made possible and viable by the promise of the sovereign-issued dollars.)

Both kinds of dollars represent a “debt”-but the debts they represent couldn’t be more different. Bank dollars represent an I.O.U. the business or citizen who received the bank loan owes to the bank. Sovereign dollars represent an I.O.U. the U.S. sovereign governmentowes to the citizens-specifically, in issuing its dollar, the sovereign is saying: “I owe the bearer of this dollar one dollar’s worth of cancelled taxes.” To repay their I.O.U. to the bank, businesses or citizens must use something (dollars) which they, themselves, cannot legally create-and for this reason they logically cannot spend more than they earn without getting into financial difficulty, defaulting on their I.O.U. and, ultimately, declaring bankruptcy. To repay its I.O.U. to the citizens, however, the sovereign has no such constraint: it does not have to create anything at all, but simply “cancels” a citizen’s or business’ tax liability-and it furthermore has the legal authority to create new tax liabilities to replace the ones that have been canceled, and to issue more of its I.O.U.s (sovereign dollars) as the need arises. The U.S. sovereign government, then, can, does-and, in fact, must-issue sovereign currency by fiat on a continuing basis to keep the whole monetary system (including the private banking system) rolling along. This fact, however, is hidden-and the hiding of it causes enormous confusion and dysfunction in our collective governance.

The obscuring of the distinction between sovereign dollars and bank dollars-and the fact that both kinds of money run simultaneously through the U.S. banking system without any distinction at all-gives rise to the confusing illusion that, in fact, only ONE kind of money exists-the bank dollars we see ourselves earning and spending and borrowing every day. The sovereign’s operation of issuing its fiat currency is, somehow, completely “invisible”. This concealed reality, in turn, gives rise to the even greater confusion that collective goods and services (those which are paid for by the U.S. sovereign government) must therefore, by logic, be paid for with the bank dollars as well (the only kind of money we think exists!) And how will the sovereign government obtain the bank dollars it needs to pay for collective goods? It must (obviously) collect them in taxes-or alternatively borrow them from the private sector economy.

Thus we imagine that, as a collective society, we pay ourselves to create collective goods and services by the following convoluted process: (a) banks make loans to private businesses and citizens, (b) the sovereign government converts those “loan” dollars to real dollars, (c) the sovereign then collects some of those real dollars as tax payments which it then (d) pays back to the citizens in exchange for the needed collective goods. A few moments of reflection should reveal why this imagined reality is, at its deepest level, impossibly illogical:

Step (b) acknowledges that the sovereign power, in fact, creates the “real” dollars by fiat (out of thin air)-however the quantity of “real” dollars it creates is implicitly limited by the willingness of U.S. citizens and businesses to borrow bank dollars. This, in turn, following steps (c) and (d), limits the quantity of dollars the sovereign can obtain to buy collective goods and services. By what logic, however, should the sovereign’s spending for collective goods and services be limited by what U.S. citizens and businesses are willing to borrow from banks for the purpose of creating private goods and services? If the sovereign government can, in fact, issue fiat dollars as needed (since they are only a promise to cancel federal tax liabilities) why should it be limited to issuing those fiat dollars ONLY to make bank dollars “real”? Why should it not, indeed, as a matter of course, issue sovereign dollars DIRECTLY to pay for the collective goods and services that American society needs?

Before considering the likely objections to such a “wild” suggestion, let’s observe how the confused and obscured configuration of reality just described sets the stage for two serious missteps in our collective governance:

First, many things which, by common reason, ought to be treated as collective goods and services (and therefore paid for by the sovereign’s direct issuance of fiat currency) are instead relegated to private, profit-seeking markets. This happens because of the obvious fact that if the sovereign collected enough taxes to pay for the needed goods and services, the citizens would have little money left for their private expenses! The second misstep occurs with needs which are treated as collective goods and services because (a) they’re essential to society’s survival or prosperity, while (b) private markets see no profit in producing them. Spending on these collective goods are skimped to the very minimum because of the belief the sovereign cannot be allowed to “borrow” beyond some theoretical percentage of its expenditures. These two missteps in public governance-generated by our confused construction of monetary reality-are colloquially known as “privatization” and “austerity”.

An example of the first misstep in the United States is higher education (and increasingly preK-12 education as well.) The most basic of common senses should tell us that a great collective benefit is obtained when every young adult citizen receives a secondary education-whether college or trade-school-as a matter of course. In the U.S., however, since it is obvious the sovereign government cannot collect enough taxes to pay for college or trade-school for every young adult, secondary education must be treated as a commodity provided by private markets-and paid for, by the way, with the “loan” dollars created by banks. The serious long-term social damage being done by this misguided perception is evidenced by the fact that the “value” of education itself is now being questioned! What will America gain if increasing numbers of young adults decide to enter the job market, and begin families, without any special training or skills beyond what they learned in high-school? And for those who do choose to borrow the bank dollars to acquire some special skill, what benefit does America gain when they begin their careers forty thousand dollars in debt?

The second misstep (austerity) is exemplified by the U.S. national and regional infrastructures-roads, bridges, electrical grids, water and sewer systems, etc.-which we collectively use and depend upon every waking and sleeping moment of our lives. The American Society of Civil Engineers has recently calculated this public infrastructure requires $3.6 trillion worth of maintenance and repair over the next six years-just to maintain the operational capabilities it has today! Again, the sovereign U.S. government is obviously not going to collect an extra $3.6 trillion from tax-payers to pay for this work-nor is private industry going to borrow the bank dollars to do it either, since they cannot make a profit in doing so. According to our confused and convoluted monetary logic, the only option available is for the sovereign government to borrow the $3.6 trillion from the private markets. But how can we, by logic, allow the government to do that when we know the government can never collect enough tax dollars to repay what it has borrowed? We are placed, then, in a kind of existential dilemma wherein the actual resources necessary to repair and rebuild our collective infrastructure are available (and waiting), but the U.S. sovereign government can’t tax or borrow enough dollars to employ those resources to accomplish the needed work.

With each of these examples I seem to be suggesting that direct sovereign spending-the issuing of sovereign fiat dollars to pay for collective goods and services-ought to be buying things which, by any measure, seem astronomical in “cost.” $3.6 trillion is the bill for just repairing our infrastructure. Modernizing our infrastructure to meet the pressing needs we face in the near future-flooding coastlines, water shortages, non-fossil fuel energy systems, for example-will cost at least that much again, and likely much more. The current student debt for higher education tops $1.2 trillion. After retiring that out of hand, what would be the further “cost” of paying for a secondary education for 21 million college students every year? The numbers seem staggering-and what would be the result IF Congress directed the U.S. sovereign government to simply issue the required dollars, by fiat, and SPEND them?

Well, one set of results would be that our young-adult citizens would stop dropping out of the skilled labor market, we’d get our bridges repaired and maybe a good start on preparing for and mitigating against rising sea-levels. Another set of results would be that a very large number of teachers, educators, bridge repairmen and flood-control engineers (to name just a few) would get paid new fiat dollars for their services-perhaps, in aggregate, lowering U.S. unemployment by several percentage points. What would the objections be to these results?

The primary objection, of course, is that issuing and spending all those new sovereign fiat dollars would dilute the value of U.S. currency, creating hyperinflation, sky-rocketing prices, and economic chaos. But shouldn’t we ask the simple question: What is the difference between the banking system creating new money by issuing “loan” dollars, and the sovereign power issuing new money by fiat? Framed by this question, it’s easy to see that the issue of inflation, in fact, has nothing to do with who is issuing the new dollars, but whether the new dollars issued are actually put to a use that results in the creation of new goods and services. Historically, every instance of hyperinflation has arisen because citizens have been paid a great deal of “money” without producing anything they can spend it on.

Inflation, then, cannot logically be a de facto objection to direct sovereign spending for collective goods. So long as the spending employs unused resources that are actually available-labor, materials, energy, technology-and so long as it contributes to the production of new goods and services that people can actually spend their new dollars on, the only things “threatening” us would be social progress and a level of prosperity our myopic confusion about “money” cannot even dream of.