It never ceases to amaze me how people seem to misinterpret what happens in the process of federal finance. At the head of the list stands this ridiculous economic stimulus program that the government has adopted. The chatter about the federal deficit probably stands second in line.
To provide a basis for conversations about these and other government finance issues I thought a simple explanation of the dynamics of federal finance would help.
How the Government Spends Money
To understand government finance you must first understand what people generally refer to as government spending. Although I do use the word occasionally, I try to avoid “spending” when referring to the money government disburses. To me spending implies voluntary exchanges with earned resources (or money). Governments do not earn money.
In spite of the laundry list of programs that get money from the government, it makes three general categories of disbursements: 1) transfer payments, 2) acquisitions, and 3) debt payments. This diagram depicts those disbursements from the Federal Government to the National Economy.
As the term implies, transfer payments simply transfer money to individuals, who generally belong to some group or category of citizens (or even non-citizens). Examples of transfer payments include: Social Security, Medicare, Welfare Payments, and Economic Stimulus Payments. The government receives nothing in return for these payments.
Acquisitions include all disbursement made in return for products and services. Unlike transfer payments the government seemingly gets something for the money it disburses. Examples of acquisitions include: Defense (now known as Security), Highways, Buildings, and Salaries for Legislators and bureaucrats.
Debt payment includes all payments made on federal debt obligations. This includes principal and interest.
As many categories as the people in government invent and as many hearings and debates the legislators have the “spending” side of federal finance all boils down to these three categories: money given away, money to buy stuff, and money to pay debt obligations.
That, however, does not provide a complete picture. Every dollar that government disburses must come from somewhere. Government has no money of its own.
So, where does government get the money it disburses?
How the Government Gets Money
Coincidently and conveniently, it comes from three sources. I have completed the diagram of government finance to show those sources of money: 1) taxes, 2) inflation, and 3) borrowing.
Taxes—all forms of federal taxes—provide the primary source of money for the disbursement described above. (I have included use fees in taxes because the market has not determined these fees.)
No matter how nicely you phrase it taxation amounts to the use of the coercive power of the government to take people’s private property. Plunder, thievery, and taxation all provide accurate names for this source of government money.
The nature and effect of government borrowing seems to confuse people second only to inflation. Most explanations of government borrowing tend to complicate the subject beyond comprehension.
First, why does government borrowing occur?
As depicted in the diagram, the government must have a source for every dollar it disburses. Taxes provide the money for most of those disbursements, but when the government intends to spend more than it expects to collect in taxes (and it doesn’t want to just print money) it must borrow to cover the deficit.
Second, what effect does borrowing have on the national economy?
In simple terms, borrowing has no different effect than does taxation. It takes money from the national economy. Just as with taxation, when the government borrows money from the economy, that money gets used as government authorities dictate. It is no longer available for any other purpose for which the free market might have used it.
Third, what secures government borrowing? Or, what provides assurance of repayment to lenders?
People don’t lend money without the expectation of getting it back. When people lend money to governments they rely on the government’s ability to tax in order to repay those loans. The security for government borrowing lies in its ability to tax.
(I don’t have the space to elaborate here, but don’t get confuse by people to talk about “borrowing against our kids’ future.” First, money borrowed by government comes out of the economy today—not in the future. Second, when government makes the debt payment disbursement in the future, government extracts that money from the economy at that same time in the future.)
Because the government controls our money it has the power to create new money at will. In order to make any of the disbursements described above it can simply make new money and pass it out. The Government likes this method for “collecting” revenue for a number of reasons: it can do it unilaterally, it can do it without people noticing, and people don’t feel the pain immediately.
I have depicted inflation as a receipt like the other sources of revenue because inflation takes value away from people in the economy—just as taxation does. When the government creates new money—from nothing—the value of all money already in existence declines. The government has just taken value from your checking account, your savings account, and the money in your mattress.
Although the government has the power to create money for any purpose, it generally does so to make debt payments—frequently referred to as monetizing federal debt. That does not change the effect of inflation: reducing the value of all money.
The Books Must Balance
For every dollar the government disburses it must receive a dollar. Disbursements and receipts must always equal. Simple. Keep this in mind whenever reading or hearing about government finances.
When your legislators propose wonderful sounding programs (e.g. healthcare, museums, homeland security, or economic stimulus) they must tax, borrow, or inflate to get that money.
Similarly, when they propose tax cuts without spending cuts, don’t let that fool you. They must borrow or inflate to make up the difference.
But this system looks rather benign. Doesn’t the government put back into the economy every dollar it takes?
Yes, it does. However…
A Flaw in the Model
That last question exposes the flaw with the model I have presented here. The homogenous entity that we refer to as “National Economy” simply does not exist. The economy actually exists of an interconnected, yet heterogeneous, collection on individual people and businesses.
Transfer payments, acquisitions, and debt payments to not go to everyone equally. The government makes those disbursements to specific people or organizations.
Taxes, borrowing, and inflation do not come from individual people and businesses uniformly. Specific people or organizations pay taxes, lend money, or suffer from the effects of inflation.
The Wealth Redistribution Machine
In summary, the federal government acts as a gigantic wealth redistribution machine. In the aggregate, the government gives a dollar for every dollar it takes. The economy, however, does not operate as an aggregate. So for every dollar the government gives to one group of individuals, it must take a dollar from another group of individuals.
Government finance simply amounts to exchange by coercion.