Soft Currency Economics

[Dovahkiin]

This may be one of the most eye opening readings I have had the pleasure of reading. It has "freed" me from the neoclassical religion that dominates economics.
Soft Curency Economics paper

The deficit doves and deficit hawks who debate the consequences of fiscal policy both accept traditional perceptions of federal borrowing. Both sides of the argument accept the premise that the federal government borrows money to fund expenditures. They differ only in their analysis of the deficit's effects. For example, doves may argue that since the budget does not discern between capital investment and consumption expenditures, the deficit is overstated. Or, that since we are primarily borrowing from ourselves, the burden is overstated. But even if policy makers are convinced that the current deficit is a relatively minor problem, the possibility that a certain fiscal policy initiative might inadvertently result in a high deficit, or that we may owe the money to foreigners, imposes a high risk. It is believed that federal deficits undermine the financial integrity of the nation.

Policy makers have been grossly misled by an obsolete and non-applicable fiscal and monetary understanding. Consequently, we face continued economic under-performance.

The purpose of this work is to clearly demonstrate, through pure force of logic, that much of the public debate on many of today's economic issues is invalid, often going so far as to confuse costs with benefits. This is not an effort to change the financial system. It is an effort to provide insight into the fiat monetary system, a very effective system that is currently in place.

The validity of the current thinking about the federal budget deficit and the federal debt will be challenged in a way that supersedes both the hawks and the doves. Once we realize that the deficit can present no financial risk, it will be evident that spending programs should be evaluated on their real economic benefits, and weighed against their real economic costs. Similarly, a meaningful analysis of tax changes evaluates their impact on the economy, not the impact on the deficit. It will also be shown that taxed advantaged savings incentives are creating a need for deficit spending.

The discussion will begin with an explanation of fiat money, and outline key elements of the operation of the banking system. The following points will be brought into focus:

• Monetary policy sets the price of money, which only indirectly determines the quantity. It will be shown that the overnight interest rate is the primary tool of monetary policy. The Federal Reserve sets the overnight interest rate, the price of money, by adding and draining reserves. Government spending, taxation, and borrowing can also add and drain reserves from the banking system and, therefore, are part of that process.
• The money multiplier concept is backwards. Changes in the money supply cause changes in bank reserves and the monetary base, not vice versa.
• Debt monetization cannot and does not take place.
• The imperative behind federal borrowing is to drain excess reserves from the banking system, to support the overnight interest rate. It is not to fund untaxed spending. Untaxed government spending (deficit spending) as a matter of course creates an equal amount of excess reserves in the banking system. Government borrowing is a reserve drain, which functions to support the fed funds rate mandated by the Federal Reserve Board of Governors.
• The federal debt is actually an interest rate maintenance account (IRMA).
• Fiscal policy determines the amount of new money directly created by the federal government. Briefly, deficit spending is the direct creation of new money. When the federal government spends and then borrows, a deposit in the form of a treasury security is created. The national debt is essentially equal to all of the new money directly created by fiscal policy.
• Options over spending, taxation, and borrowing, however, are not limited by the process itself but by the desirability of the economic outcomes. The amount and nature of federal spending as well as the structure of the tax code and interest rate maintenance (borrowing) have major economic ramifications. The decision of how much money to borrow and how much to tax can be based on the economic effect of varying the mix, and need not focus solely on the mix itself (such as balancing the budget).

Finally, the conclusion will incorporate five additional discussions:

• What if no one buys the debt?
• How the government manages to spend as much as it does and not cause hyper-inflation.
• Full employment AND price stability
• Taxation.
• A discussion of foreign trade.

Much more detail is provided at the link.