China and the US have different social systems. But before I begin the narrative that is the core of this article, allow me to lay down some axioms, some essential facts and assumptions, that are universally true about all central banks, national treasuries (sometimes called finance departments) and governmental/regulatory rules concerning financial matters common in East and West, in China and America, today and yesterday.
Central banks do only two things: One is active, in that the action involved is mainly under their control and is a product of their will to act. In this instance, I refer to their power to buy and sell things using the bank’s own IOUs in payment and taking in its own IOUs when it offers deposit services to all and sundry, including its own and sometimes other governments that are its customers.
It buys and sells mainly financial products, thereby making its IOUs the common “coin of the realm,” but in theory, central banks’ influence over economic affairs remains the same if they buy and sell anything at all, from real estate to cigars that provision their boardrooms. Such buying and selling powers are only limited to the extent that the central banks must find a player on the other side of the deal from whom they buy and to whom they sell.
The second power they have is more limited: A central bank may promulgate rules that they “command” must be followed by economic players who somehow come into their sphere of influence. A key rule is that their own ”coin of the realm” will only remain in circulation so long as other economic entities, domestic and foreign, have confidence in the prudence, moderation and good judgment on the part of the management of the central bank.
As is always the case with rules, not all players will obey them, and many players operate outside of this sphere. Another typical rule says their parent government, along with favored economic entities, may keep deposits and get loans from the central bank, typically all denominated in central bank IOUs.
National treasuries do only one thing: They enter financial markets, at home and abroad, to assist in the process whereby their associated government may borrow money, domestic and foreign, and as well assist in the reverse process whereby their related government may retire (“pay off”) national debts. In so doing, they may set forth rules about holding and trading such national debt instruments (bonds, notes and other certificates and claims upon their government).
But as above, and as is true with all rules and regulations, not all affected parties will obey them, especially if gain is made by such evasion or if the central bank IOUs in which debt is typically denominated, fail to remain trustworthy.
In the latter case, the affected treasury is forced to borrow in some “better” money, usually the IOUs of the “reserve currency” nation. This situation exposes the borrowing government to a form of “bankruptcy” where its holdings of foreign exchange, that is, reserve currency usually “earned” by selling exports to the world at large, prove inadequate to meet demands that national debts, government and private, be retired in terms of the reserve currency.
Governments are further up the food chain of rule-making power; they assert the capacity to make rules for all players in the financial game, including rules for central banks and treasuries (even rules for the creation of such). In China you will get into trouble with the rules if you try to conduct your affairs using American dollars.
Back in 1935 my immigrant grandmother was forever cured of voting for Democrats after president Franklin Delano Roosevelt’s administration made it illegal for her to conduct daily economic affairs using the gold coins she had earned and saved and put away after so much hard work and sacrifice. As things turned out, she was wise to think the paper IOUs she was offered in exchange for her hoard were “just as good” in the long run.
There is no theoretical reason that central banks, or that private agents who may act as trustees for the management of government borrowing and retiring of its own debts, need be created by governments or be ruled by government fiat.
Indeed, in financial history, private banks with central-bank powers were successful. Examples are Alexander Hamilton’s First Bank of the United States (1791-1811), 80%“owned” by its private stockholders (20% by the US federal government), or the Medici Bank (1397-1494) owned by Medici family financiers in Florence (who were themselves the government).
But in today’s world, certainly in China and America, central banks and treasuries are part of government, with limited independent authority.
Now for the narrative
A longtime friend of mine, a man with exceptional financial insight and with deep understanding of international affairs, in other words a man with far more than the average intellectual’s grasp of world affairs and who has been often consulted by world leaders on matters of high significance, wrote to me asking the questions below.
In part, he may have been making a joke, because he understands the workings of central banks, and the intricacies of international finance to a degree rarely matched, even in the elite policy-adviser community in which he operates. It is likely he knows a great deal about the issues and questions he poses here.
But I welcome the opportunity to reply to him here, expanding the answers to include China, and deepening my analysis to make the point that today’s international problems of combined recession/inflation are entirely man-made; they are problems that are self-inflicted: They are problems that have come into existence as a matter of choice, and they have nothing to do with economic destiny or inevitability.
They are questions of great pertinence to the current moment, and they are questions that should be put to central bankers, finance department heads and policymakers, by media in both China and America at every opportunity.
Tom’s friend: I was at a party at which there was some discussion of deficits and government financing. I was able to answer many of the questions but concerned that I could not give definitive answers to others. Since you’re the expert, I’d appreciate some help.
Tom Velk: Yes, the Treasury may indeed offer documents of indebtedness to the markets, but the real issue is similar to that of King Canute, who in the original story (unlike the reverse version sometimes reported) recorded in the 12th century by Henry of Huntingdon was said to show his (Canute’s) hanger’s-on that his powers were limited by telling them that yes, he might command the tides to obey him, but the ocean was unlikely to pay much attention.
TF: If the federal budget is running a deficit, the Treasury can make up the shortfall by issuing bills, notes, and bonds. It receives cash and that makes up the difference between expenditures and revenues. I assume that’s right.
TV: It’s simple: When aggregate national debt is excessive, new lenders, when asked to refinance it, or to extend further credit, either in the debtor’s own IOUs or in reserve-currency terms, will be as deaf as the ocean was in Canute’s lesson. Interest rates go sky-high and even then, little or no money comes in.
National assets must be sold off, private and public, at pennies on the dollar, to foreign creditors, and a kind of colonization goes on, with possible future borrower dividends from natural resources, national assets and even national real estate falling into foreign control and ownership.
It takes a long time to restore international confidence in the government of the de facto defaulting nation, leading to fundamental insecurity, even including eventual military conflict, and the indebted nation seeks to recover its lost assets by force or revolution and sovereign debt repudiation.
Over 100 years ago China’s Imperial Dynasty and the Republic of China that followed it issued bonds of indebtedness based on China’s then prosperity. The bonds were never paid off. But they still exist. Not as museum items. Modern holders of these “bonds that will not die” attempted to get president Trump to ask they be paid off as part of his push to get economic concessions from modern China.
TF: What role does the Fed (the US central bank) play? I understand that it can buy securities to add to its balance sheet. Where does it get the money to pay for them? Or it can sell securities from its balance sheet. What does it do with the proceeds? What are the effects of the Fed buying or selling securities for its balance sheet? Do these actions affect the surplus or deficit in any way?
TV: As above, a central bank may buy its own government’s bonds (it can buy anything) with its own IOUs. Indeed, a large percentage of this past year’s US government debt was purchased by the US central bank. It is rumored that 52% of last year’s deficit was financed by a combination of US-government-controlled financial entities (pension funds, the Fed, the Social Security system etc).
One hand of government is borrowing, and the other hand is lending!
TF: What else does the Fed do besides setting interest rates?
TV: Central banks do not control or set interest rates any more than King Canute may control the tides. The real interest rate is a complex function of real growth in the rate of profit, the real rate of growth, the degree of risk as seen by savers and investors, along with other interest rates available in other nations’ credit markets.
When local central banks claim to raise or lower interest rates, they refer to the effect their own buying or selling of financial products in domestic markets will have on the price of these financial instruments as compared with the dividends or earnings made by those products.
If the earnings remain constant while central-bank buying pressure raises the price of the product, the ratio of dividends over price, that is, the interest rate earned, falls, and vice versa. Sometimes the central bank will lend directly to (or borrow directly from) other players in financial markets, thereby creating a surplus of credit (rates down) or a scarcity (rates up).
But none of this game may be played by a central bank that has lost credibility due to immoderate, imprudent, careless spending and financial mismanagement. Its IOUs sell, if at all, at great discounts. Better-managed currencies, reserve currencies, despite rules against it, take over the local economy, and interest rates are dictated by international forces.
TF: Under what circumstances can the Fed print money? Are the currency notes backed by anything other than the full faith and credit of the US? How is the decision reached as to how much money to print at any point in time? What factors affect that decision? Are there limits on how much can be printed?
TV: Actual, literal printing of money is everywhere controlled by the demand for currency as opposed to all the other forms of buying power available in today’s innovative financial product markets.
Internet transfers, credit cards, crypto markets, flashing lights on the screens that report transactions in stock, bond, currency markets and even auction houses, all compete with old-fashioned paper-money central-bank IOUs as means of payment, stores of value, units of account, standards of value and devices used to settle illicit accounts in the dark economy.
Eighty percent of all US currency is held outside the USA and 77% of all US currency by value consists of 100-dollar bills. There are more hundred-dollar bills in circulation than there are one-dollar bills. This tells me that a good part of the demand for actual US currency is to provide “reserve currency” for honest and dishonest trade in markets where users don’t want records to be kept and in markets the world over where domestic central-bank IOUs are not respected.
When any kind of economic agent wants more currency, they [turn] to a financial entity that has a connection with the central bank and ask for the currency needed, offer something of value in exchange (any among many financial instruments including a debt against the demander). The obliging financial intermediary, having an account with the central bank, draws upon it in terms of currency, and hands it to the demander.
The central bank (sometimes the Treasury) is the actor who restores its own stock of currency by asking the mint or a department of printing and engraving, usually a part of the Treasury or some other arm of government. The central bank “pays for” the new notes by itself issuing new IOUs in favor of the printers, or by a simple accounting note on its own books. Those notes are balanced by companion notes at the Treasury.
If you speak colloquially, you refer to “printing money” as the act of government spending “money” in the sense that government budgets show that expenditures exceed revenues, and the gap is covered by some kind of borrowing or even by natural asset sales, government sales of natural resources (“owned” by government or taken from private hands) to international buyers, seizure of foreign-owned assets, especially natural resources, taken without adequate compensation, or foreign assets seized by military means.
Simple debt repudiation takes place at this time. These last “sources” of government spending power are acquired by taking serious risks to national sovereignty and are a sign that the indebted nation is in serious trouble.
Excessive borrowing may lead to such risk-taking if spending continues to exceed incoming legitimate revenues into the medium to long run. Many revolutionary societies end their days as “bankable” entities when they resort to these peculiar forms of “printing money.”
Conclusion
As promised at the beginning of my narrative, I hope I have shown that the sort of “money printing,” spending in excess of revenues, issuance of “bad IOUs” and other forms of financial imprudence, immoderation, unwise and improvident financial behavior on the part of government is almost always a conscious act.
Such behavior is known to result in the state of affairs we see not just in China and the USA but in much of the world: The result, in its early stages, is the combination of recession and inflation.
The slide into more dangerous economic instability becomes ever more likely as long as money is created faster than is goods production, as long as private and public economic actors spend faster than earnings come in, and as long at the citizenry fails to demand better behavior.
On that last point, among other reforms, citizens need to figuratively and literally return the checks they get from politicians who are, when they send the money out, counting on our shortsightedness.
Is it unrealistic to expect better from politicians? Is it likely that the citizenry will be wise enough to accept the necessity of (figuratively speaking here) “send back” all the various forms of “checks in the mail” with which our attention is distracted?
I have turned the narrative around. In making my replies, I ended up asking more questions. I hope you, dear reader, have good answers.
Tom Velk is a libertarian-leaning American economist who writes and lives in Montreal, Canada. He has served as visiting professor at the Board of Governors of the US Federal Reserve system, at the US Congress and as the chairman of the North American Studies program at McGill University and a professor in that university’s Economics Department.