U.S. Facing Insolvency by Ignorant Choice

by Derryl Hermanutz

In his book, “The 7 Deadly Innocent Frauds of Economic Policy”, modern money theory (MMT) advocate Warren Mosler distinguishes between three very different kinds of money systems,

“Historically, there have been three categories of money: commodity, credit, and fiat. Commodity money consists of some durable material of intrinsic value, typically gold or silver coin, which has some value other than as a medium of exchange. Gold and silver have industrial uses as well as an aesthetic value as jewelry. Credit money refers to the liability of some individual or firm, usually a checkable bank deposit. Fiat money is a tax credit not backed by any tangible asset. In 1971 the Nixon administration abandoned the gold standard and adopted a fiat monetary system, substantially altering what looked like the same currency. Under a fiat monetary system, money is an accepted medium of exchange only because the government requires it for tax payments.”

Warren lists three kinds of money: commodity, credit and fiat.  We are no longer on gold, so which type of money are we now using?  Warren says we adopted fiat money in 1971.  A point I have repeatedly tried to make to anyone who will listen is that, even though it legally and constitutionally could, the US government does not in fact issue fiat money and has not done so since Lincoln and Kennedy issued United States Notes.  Fiat money would be United States Notes, or proof platinum coins.  These forms of fiat money would be issued directly by the Treasury department as “money”, not issued by the banking system and loaned to the government as “debt”.

In a credit money system, the banking system that issues the money, and the economy (including government) that borrows and uses the money, are monetary opposites.  Our money is the banking system’s liability, and our debts are the banking systems assets; our debts are our liability, and our money is our asset.  What is an asset to the economy is a liability to the banking system, and vice versa.

Monetary Opposites

The economy’s “debts” are “assets” to banks, because borrowers agree to pay interest on the loans of credit money in addition to promising to repay the principal.  The economy’s “money” is a “liability” to banks, because they loaned that money into existence, and it is their legal responsibility to see that borrowers pay it back.  And in the case of CDs and savings account balances, banks also have to pay interest on the economy’s deposits of money in the banking system.

Credit money is issued as a “loan” against an “asset”.  Ultimately the asset is simply the borrower’s “promise” to pay interest and repay the loan principal, but the legal asset backing all credit money loans is the “promissory note”, duly signed by the borrower, that lays out the details of the borrower’s repayment obligations to the bank. Most notes are backed by collateral, real estate, cars, etc. that the borrower pledges against his promise to repay.  If he fails to repay as per the terms of the loan, the debtor has authorized the lender to seize ownership of the collateral he pledged.

Credit Money

Under current operations the U.S. government writes promissory notes called bonds, bill or notes, promising to repay the principal and pay (what amounts to) interest on the outstanding loan balance, and primary dealer banks (PDs) buy these at auction.  The PDs pay for their purchases in the same way that all banks buy “assets”:  by creating a deposit of bank credit money for Treasury.  The new bank deposits are “money” that Treasury can now spend.  Treasury’s promises of repayment are “debts” to the government and the taxpayer.

Credit money is created by banking systems, not by governments (unless governments go into the banking business like North Dakota has).  So governments, just like the rest of us who aren’t banks, can only spend more than we earn by borrowing credit money from bankers, and our deficit spending increases the total amount of “debt” we have promised to eventually repay to our banking system.

Compounding Liabilities and Credit Limits

All borrowers have “credit limits” or debt ceilings, which are on the one hand somewhat arbitrarily imposed by lenders or by borrowers based on estimates of our capacity to pay interest out of our present incomes and repay principal out of our future incomes; but on the other hand real limits are inescapably imposed by the exponential arithmetic of compound interest on the total stock of debt.

Applying “the rule of 72”, 72 divided by the average interest rate on the total debt, gives the number of years it takes for the debt to numerically double.  So at 7.2% interest (loan interest is historically in the 6-8% range), debt doubles in 10 years if interest liability accumulates, then doubles again in 10 more years, etc.  2, 4, 8, 16, 32, 64, 128, 256, 512, 1024, 2048: you can see how after a few iterations of compound interest the borrower owes THOUSANDS of times the original principal balance, if the borrower keeps rolling over the loan principal and borrowing new money to pay old interest.

Rolled over debt grows exponentially toward infinity under the intransigent arithmetic of compound interest, and this imposes a hard ceiling on the total amount of credit money an economy can afford to borrow at interest, without going into hyperinflation.

Maintaining the Money Supply

To keep the economy’s total stock of debt, which is the total money supply, constant or rising, new borrowers must always be taking out new loans as old borrowers are repaying.  It is not the same individuals rolling over old debt each year, but to maintain a constant money supply the economy as a whole must constantly keep rolling over its total stock of debt, and constantly pay interest on the total stock of debt. So debt grows exponentially and credit money is not a sustainable system, as a graph of post-WWII debt growth and the current global debt crisis should be demonstrating to everyone’s satisfaction.  We have passed the limit where this kind of money can “work” in our economy, and the system is now collapsing.

Fiat Money – A System We Don’t Use

As an alternative to borrowing credit money that is created by its national banking system, the government could create its own fiat money and spend it into the economy without incurring any repayable “debt” in the process and without saddling taxpayers with escalating interest payments.  As things stand today, taxpayers cannot even make payments on their private debts, let alone adding public debts to their unpayable burden.  What the economy needs is additional income, not more debt.

Fiat money created by government and spent into the economy would be a net addition to the money supply that circulates in the economy, unless and until the government decided to tax some of that money back out of circulation and extinguish the money.  Money that is “spent” into the economy by government becomes “income” to the people who receive the money.  So fiat money offers a way to add positive money numbers into our monetary equation that is currently drowning in negative numbers.

This is the MMT that Warren writes about, but it only applies to a fiat money system where governments in fact issue their own non-debt money.  It doesn’t apply where governments borrow the money that they spend above government revenues.

Vertical vs. Horizontal Money

This fiat money process, where government creates its own non-debt money and spends it into the economy, would add “vertical” money into the economy, a net addition to the money supply, money that is not “owed” to anybody as repayment of a loan or a bond or any other kind of “debt”.  All credit money that is issued as debt which must be repaid is, on the other hand, “horizontal money” that only exists as long as the loan balance that created it is outstanding.  As the loan principal is repaid, the horizontal money is extinguished and ceases to exist.

All credit money is horizontal money.  All money that is borrowed into existence and which must be repaid and extinguished, exists only as long as the borrower remains “in debt” to the lender/money creator.  Only government fiat non-debt money can be “permanent” vertical money.  Only government fiat money can be spent into circulation as an addition to the money supply (and an addition to the national income) without adding to the economy’s total debt to its banking system.

The Government DOES NOT ISSUE Money

But the government is not issuing any non-debt money.  There are no platinum coins or U.S. Notes.  Instead, the government uses the same credit money that the rest of the economy uses, money borrowed from the banking system, money that is owed as debt.

Warren’s “frauds” apply to a fiat money system where the government issues its own money.  But in the credit money system that our governments actually use, the frauds become “facts”.  All credit money is borrowed into existence and must be repaid according to the terms of the loan, so all of the arithmetic constraints of zero sum balance sheet credit money that apply to other private borrowers also apply to the current financial operations of the U.S. government.

The government SHOULD be a money issuer, according to us MMTers.  But in fact the government behaves as a money “user”, borrowing credit money from its banking system (i.e. from the primary dealer banks who bid at Treasury auctions and buy the new Treasuries with newly created bank deposits that become the “money” that Treasury then deficit spends into the economy) to fund deficit spending.

The bonds and other Treasury securities are all acknowledgments of “repayable debts”.  They are promissory notes, where the borrower (government) promises to repay principal plus interest according to the terms of the bond or security or other debt instrument against which a commercial bank created a deposit.

The Banks Issue Money

Credit money is issued as bank deposits by the banking system.  Credit money is a balance sheet equation, where all of the money that is issued as “deposits” is exactly offset by “debts” that must be repaid.  The money on one side of the equation is offset by the debt on the other side, so the equation sums to zero.

Zero Sum Money

Credit money is spent into the economy by borrowers and is ultimately removed from the economy by those same borrowers to repay their loans.  A bank loan of credit money creates a deposit in the banking system, and a borrower repayment destroys that deposit.

Just as taxation extinguishes fiat money, so loan repayment extinguishes credit money.  The loan created a positive number of money and an equal negative number of debt.  When the money meets the debt in a loan repayment, the positive number extinguishes the negative number, leaving zero money and zero debt on the balance sheet.

In a credit money system, money and debt net out to zero.  All of the money is always owed by its original borrower as repayment of a debt to the banking system.  So even though many borrowers are spending newly loaned credit money into the economy and removing money from the economy in different timeframes, the fact remains that all of the money at all times is owed as debt to the banking system that created it as bank deposits.  The total stock of money is always owed as debt to the banking system that created it.

By law, bank deposits are convertible into the central bank’s banknotes, dollar bills and $5s and $20s.  But commercial banks must borrow banknotes from their central bank, so even the “cash” that is printed by a credit money system comes into circulation as a debt, because the commercial bank owes the cash to its central bank as repayment of the banknotes it borrowed.

Repeat Again – The U.S. Does Not Use Fiat Money

Neither the cash nor the bank deposits in our credit money system are issued as “fiat money” by the government.  This fact, that we are not using government fiat money but are instead using private bank credit money, is the ONLY ‘deadly fraud’ we need to focus on at this point.  Because unless the bankrupt and insolvent governments of the world actually start exercising their constitutional authority to issue some of their own non-debt fiat money, they truly are bankrupt and insolvent just as the Austerians claim.

Europeans are already trapped in a system that has stripped nations of fiat money powers.  They have no alternatives other than to borrow more euros from euro-issuing bankers (or from hedge funds and other privately owned pools of money) or balance their budgets.  If the lenders say no then these nations have NO MONEY to deficit spend, and they are FORCED by arithmetic necessity to balance their budgets, just like you and me.  We have no power to print or create money, so we must live within whatever limits our incomes and our creditors impose on our spending power.

Other potentially sovereign nations, like the U.S., technically possess fiat money powers but in fact do not exercise them.  If you have a fire extinguisher, but don’t use it, you still burn down.  “Potential” powers don’t put out “actual” fires.

The U.S. is Insolvent ONLY if It Chooses to Be

So it may be “voluntary” bankruptcy, but that doesn’t change the essential fact that it is still bankruptcy, followed by asset fire sales of whatever the government owns and the banksters want.  This has been going on all over the Third World for 50 years under IMF structural adjustment programs and other “shock doctrine” tactics.  Now it’s coming home to a First World nation near you.  The ONLY alternative to this Austerian bankster paradise is government issuance of its own non-debt fiat money.  But if governments won’t do that, then Austerianism is what we can look forward to in the near future.

Related Articles

USA in 2012/2016:  An Insolvent and Ungovernable Country by GEAB, LEAP/W2020

Analysis and Opinion articles about MMT (Modern Monetary Theory)

Analysis articles about Money

About the Author


Derryl Hermanutz has contributed (opinion and analysis) previously on topics related to theory of money and relationships between current events and economic history and philosophy.


10 replies on “U.S. Facing Insolvency by Ignorant Choice”

  1. Talvez – – –

    Your comment is so short I may have misinterpreted its objective. My first thought is that you have not recognized the author’s primary point – that the use of credit (issued by the government only) to create U.S. money is poor policy, in his opinion. His contention is that there should also be non-debt money creation, true fiat money.

    If I have misread where you were pointing with your comment, I apologize.

    John Lounsbury

  2. «But commercial banks must borrow banknotes from their central bank, so even the “cash” that is printed by a credit money system comes into circulation as a debt, because the commercial bank owes the cash to its central bank as repayment of the banknotes it borrowed.»
    From here I infer that the source of money creation is the Central bank. I’m don’t know much about Fed and Reserve banking and that was the point of my question. Is the Fed who lends the money into existence?

    If it happens in that way, what I wonder is that given the FED is a public institution and that all profits from the FED go to the Treasury, doesn’t that mean that the Government’s money is not originated by debt (since it is basically owing itself) and actually fiat money?

    About the author’s point, I agree. It doesn’t seem very efficient to issue bonds and them let someone that buys those bonds make the money.

  3. I agree with with nearly all of the article but disagree that the US does not use fiat currency. It may be a matter of semantics but I think it’s far more useful to say that the US Government behaves as if it does not issue fiat currency by holding onto the relevant legislation and therefore I think Warren Mosler is correct.

  4. But the US Government can always pay back any debt or purchase any item denominated in dollars.

  5. Perhaps we have tied the gov hands. There is no essential reason to ever issue bonds. In fact the gov could pay off the entire debt tomorrow if it chose to, bc all the debt is in dollars and the gov prints dollars. That is not the same for Greece or you and me.

  6. Our money has nothing at all backing it up excepting it is used to pay taxes. That confers value to it bc everyone needs it to pay those pesky taxes.

  7. Talvez – – –

    Let me summarize the way it looks to me.

    The Fed, which is a private institution authorized by the government, exists for the purpose of coordinating the banking function of the nation, a collection of private businesses.

    Note: In this case I am using the term “public” to mean government and the term “private” to mean non-government. The terms can be confusing because many private companies are “publicly traded.”

    Normally, the only way the Fed creates more money (Federal Reserve notes) is by buying Treasury debt on the open market (FOMC) and they remove money from the system by selling Treasuries back to the banks. This is how bank cash reserves are increased and decreased and it is a mechanism for managing inflation and deflation by varying the amount of currency available for circulation.

    There are exceptions to what I said above (that’s why I used the word “Normally”). In the financial crisis the Fed purchased over $1 trillion in MBS (mortgage backed securities). In effect, the Fed created more money to buy assets that had already been purchased with previously issued currency and credit. This previously issued currency was not all Federal Reserve notes – almost all of it was created by leverage in the private sector. The point is that it (the previous currency) was all debt backed money in one form or another, and the new Fed notes to buy the MBS was above and beyond debt backed money to the extent that it exceeded the amount needed to cover eventual default. (See next paragraph.) The banks could use the new Fed notes (actually any Fed notes, they have no labels) to buy back MBS from the Fed balance sheet, presumably at any time.

    What has happened in the above exchange? The Fed has assumed the default liabilities of the MBS and given the banks a default risk free asset, a pile of cash (Federal Reserve notes). In other words, if any MBS held by the Fed default, the net effect is that money has been “printed” to replace money already spent for something that has become worthless. Debt money exists only until the debt is repaid or defaulted. The beneficiaries of this replacement of defaulted debt by new money to replace the default loss are the member banks of the Federal Reserve system. And the new money is really new because it is in addition to the money already released into the world when the original debt instrument was funded. The subliminal message here is that the banks were “wise” not to have worried about credit quality when they acquired these questionable MBS because they turned out to be “risk free.” That they may be encouraged to do the same process again in the future is called “moral hazard.”

    An aside: It appears that the moral hazard argument which has been used as an excuse why the bailout could not have been applied to mortgagors (home owners who took out mortgages) has not applied to the mortgagees (those who issued and held the mortgages). Moral hazard is a one-way street and demonstrates the location of political power.

    So, all of this and I haven’t gotten to your question. Let’s get back to that.

    Since the Fed is essentially a GSE (government sponsored enterprise) it is not actually part of the government unless nationalized, like AIG, Fannie and Freddie are and GM was. Of course AIG and GM were never GSEs, but I thought I would mention their nationalization skeletons anyway. The Fed serves, by government delegation in 1913, as the approved printer of U.S. currency. The U.S. government has, from time to time, printed pure fiat currency, most notably the greenbacks of the Civil War period, plus Treasury silver certificates, as well as gold (and other) coins. But the predominant “carrying around money” is and has been for almost a century, Federal Reserve notes.

    Note: Only a small fraction of the money in the world is actually currency – most is in credit and debit accounts in the banking system.

    Okay, John: Focus! Under normal circumstances the Fed creates currency and accounts of credit by buying U.S. Treasuries from the primary dealer banks (PD) and so money is created to fund Federal debt that exceeds the amount that the private economy would support with the previous level of money. It is not done by direct transaction with the Treasury but through PD banks who buy Treasuries from the government and trade them in publicly traded markets. The Fed creates money when there is not enough money already available to fund current levels of government debt.

    The Fed “destroys” money by selling Treasuries from its balance sheet (to the PD banks) when there is too much money which is driving up the price of available Treasury debt and producing market interest rates which are too accommodating and increase inflation risks.

    So (finally!) it is the Treasury who borrows money from the banking system to fund expenditures not covered by tax revenues (deficits) and it is the Fed that provides (“prints”) the amount needed to cover what the banks and other investors do not absorb. When the Fed does not supply enough new money to cover the shortfall at any given market interest rate, the rates are driven higher until market demand becomes sufficient to clear the needed funding. If the Fed supplies more than enough money to cover new issuance and therefore removes old Treasuries from the market the public demand for a scarce commodity increases and the price of bonds is driven higher at public auction of new Treasuries and interest rates are driven down.

    Answer number 1: The Fed is not part of the government but it does return it’s net earnings (maybe only from Treasuries???) to the Treasury. That is significant with the balance sheet containing well over $1 trillion in Treasuries, but the government is paying interest on well over 90% of all Treasury debt outstanding and not on the Fed balance sheet.

    Answer number 2: Without the issuance of Federal debt the Fed will not create any money unless they accumulate private debt (as they have recently with MBS) on the balance sheet. So normally, it is the government that borrows money, part of which is then replaced in the system by the Fed through FOMC (Fed Open Market Committee) actions. Since all the money the government borrows is spent the amount of money in circulation increases when the FOMC buys Treasuries. (Remember only a little is currency, most is in the form of bank credits and debits.) Thus, it is not that the government LENDS money into existence, the government BORROWS money into existence.

    Two final points:

    1. The federal deficits provide for an expanding money supply and enable growth in the private sector. Because Treasury debt is a secure “investment” the amounts held by banks can be used for reserves and leveraged through fractional reserve banking. The “excess” that can not be absorbed by the banking system and savings by the public can be “bought” by the FOMC with newly created money. Thus, every dollar of federal deficit expands the “money in circulation” by more than one dollar, expanding the money supply by more than the actual deficit.

    2. The current system requires that the government (with tax revenues) pay for the creation of expanded money supply with interest payments on 90-95% of the federal debt. This money is needed by the private sector (business) to “make the world go ’round). The current situation is a taxpayer subsidy to business. The thrust of the MMT argument is that the money should be the government’s money used by the banks and not the banks’ money used by the government. In the MMT world, any interest should be paid by banks (and other users of money) to the government. When monetary stimulus is needed the interest charged by the government could be lowered (even to zero at times). In such a situation one operational schema would have the government lending money into existence. The government would have the option of lending to expand the money supply or actually printing or coining additional currency.

    There are many operational details undefined in various potential ways that true fiat money could be implemented. But the several conceptual descriptions developed have pointed out fundamental sustainability problems of the current system where more and more economic (monetary) power and control end up in a few private hands with the creation of a debtor serfdom for the vast majority of the population. Some means of maintaining a level capitalistic playing field must be defined or the system will eventually collapse in a violent and destructive manner.

    This long winded rant may serve as a challenge to those who think I have misstated something (or everything).

    If so, please add clarifying comments.

  8. The Tay sells to pd and the fed buys from them. The fed is a creature of congress and IMO should be combined with treasury.

    The gov does create money when there is a deficit. Net financial assets are added to the private economy assuming the current account is zero or net export.

    The fed controls interest rates by buying or selling bonds and by the funds rate.

    When s&p downgraded our debt, interest on it went down. Japan also has low rates of interest and their debt is m twice our compared to GDP. They have a lower rating.

    It is impossible for the gov to go bust, as you know,since we issue the money the debt is denominated in, unlike Greece or you and me.

    The dollar has value precisely as warren said. You need it to pay taxes.

    The gov sector is spending less taxes. When that is in deficit, it necessarily means the private sector is positive leaving foreign sector aside.

    A few other things I would add. Since the gov can go bust,we should repeal that silly debt limit law. But as your title says, we can be ignorant about and force ourselves to default. Just nonsense, but does not change anything warren said in the 7IF.

  9. The Tsy sells bonds to PD and the Fed buys it from the PD, so at this point it is just as if the TSY sold them to the Fed. The fed was created by congress. It can and should be combined with the TSY to stop some of the unnecessary operations and silliness.
    A deficit necessarily creates a surplus in the private sector leaving the foreign balance aside, and that does create money.
    The federal government can never go bust like you or me or Greece or Germany, bc it can always pay any debt denominated in dollars. I imagine myself going to see Ben and Timmy with my $1000 bond and them telling me they are broke. I’ll ask them to start the presses and pay me in twenties and then I will go down to my local chase bank and deposit it in my savings account.
    You said above that we can be ignorant, I suppose like this past summer. Only we can drive us into insolvency through ignorance. That debt limit law should be repealed.
    The Fed controls the interest rates through its operations.
    When s&p downgraded our debt the interest rates on TSY bonds went down. Japan also enjoys low interest rates and it has a debt ration of twice GDP.
    Money gets its value from taxes. You need it to pay them. So Warren is absolutely right about that and IMO the other things in the 7IF.
    One other thing. Someone will have to explain to me one day, why the tsy has to issue bonds at all. I mean China is not loaning us a nickel. They are using tsy bonds to save all the money they got from Walmart. They could put them in banks savings accounts. Must figure tsy is pretty safe. Better than euro I guess.

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