When I was a little kid, my entire world was turned upside down the day I realized my parents had once been children like me. From a child’s point of view, how could I have thought any differently? The world didn’t work the way I thought it did and it was upsetting for me to recognize reality.
As both children and adults, we naturally interpret the world from our own limited set of experiences and our personal points of view. For thousands of years we humans all thought the sun and stars revolved around the earth - a logical conclusion given our point of view. Imagine how upset people must have been when Copernicus discovered the earth isn’t the center of the universe.
As we get older, more experienced, more educated, and wiser, most of us overcome these errors in our understanding of how the world works. However, there’s one very big error in our understanding that the majority of people still have to overcome. And I know many people will be very upset when they recognize this reality.
Imagine you’re a kid playing on a hot summer day on a flat, wet beach, just above the water line. You have your shovel and your bucket and your mom says, “give me a bucket of sand”. So you dig a hole and fill your bucket with the sand from that hole. Hold that image in your mind - a hole in the sand and a bucket filled with the sand from the hole. Got it?
THAT is double-entry bookkeeping. You start with a flat beach, dig sand out of the beach to create a hole and put the sand you dug into a bucket sitting on the beach. The left side of the bookkeeping entry is negative - a debit - the hole in the sand. The right side of the entry is positive - a credit - the bucket of sand that made the hole. In double entry bookkeeping, the ledger must always be balanced with a debit and a credit - a hole and a bucket.
Double-entry bookkeeping is how all financial transactions occur. When you earn a paycheck, your employer credits your bank account and debits theirs. When your company’s customer’s pay, they debit their bank account and credit your company’s bank account. When you buy a mocha latte, you debit your bank account and credit the coffee shop’s. All financial transactions dig a hole and fill a bucket - debits and credits.
Banks do the same process to loan you dollars. But banks don’t actually loan you dollars that someone else has deposited into the bank. Instead they simply credit your account with your brand new, freshly created loan dollars (which are simply keystroke-created digits in an account), while creating a loan account and debiting it by the same amount of dollars you were credited. As long as the ledger balances - as long as your “positive” dollars equal the “negative dollars” you owe - the US Federal Reserve, which is the clearinghouse for all banking transactions, is OK with it.
That’s right. Banks create “new” dollars every time they create a loan. Imagine you took out a $20,000 loan (at zero percent interest). Your bank account is suddenly credited with $20,000. You write checks from that bank account, distributing those dollars to whoever you spend the money on, with all those dollars eventually ending up in other people’s bank accounts. Eventually, $20,000 dollars are circulated into the economy from your loan and your account is down to zero.
At any moment in time during the life of the loan, the size of the hole and the amount of sand remaining in the bucket are equal in size. If you still owe $10,000 on the principle of the loan, the loan account at the bank is still negative $10,000. As long as the debit and the credit are the same amount and add up to zero, everything works out fine. As you repay the loan, you gradually take $20,000 back out of the economy, giving it all to the bank which essentially destroys those dollars - they fill the hole with the sand - leaving the same amount of dollars in the economy that were there before you got the loan - no new dollars in the economy - the hole in the beach is filled and the beach is flat again.
You might ask “how does the bank make money off this deal”? The answer is “Interest on the loan”. The example above was considering a loan with no interest paid. If you’ve ever had a mortgage, car loan, or any other type of loan, you know that over the life of the loan, depending on the interest rate and how long you have to pay it back, you could pay the bank close to twice the amount of the original loan.
You might ask, where do the dollars to pay the interest come from? Good point. The macro-economic perspective on this is covered below. The micro-economic perspective is suitable for another entire essay.
Banks dig a hole in the beach, give you the sand and keep the hole, which you will then gradually fill to the level of the beach, and then provide what might be a whole-nother bucket full of sand over the next decade. That promise to fill the hole and the new bucket is valuable to the bank because they can sell that hole and your promise to fill it back up, and your addition of more sand (the interest).
Did you catch that? The holes in the sand, the debits that will gradually be filled over time - the “DEBT” - is offered for sale as “BONDS”.
Bonds are attractive for banks because instead of waiting twenty years for you to repay your mortgage, they get other people to refill that hole immediately and they might even get out of the entire loan transaction. Anyone can “invest in” bonds and when they do, they essentially repay the bank for the new dollars the bank created to credit the loan. Investors “buy” bonds by giving the bank the dollars to refill the hole. In exchange for those dollars to fill the hole, the investor then gets the interest payments on the loan. When the entire loan is paid off, the investor gets his original investment dollars back plus the interest payments - the additional bucket of sand plus the extra sand provided to fill the hole. Bonds are time-deposits. You put your dollars into an account and collect them back at a specific date in the future, plus interest.
To review: US Banks create new US dollars every time they create a loan. They do this as agents for the US Treasury. The catch is that every dollar created by a bank as a loan requires many more dollars than originally created to pay that loan back. From the macro-economic perspective, the roughly fourteen TRILLION dollars in US credit - new dollars created by banks as loans for business loans, mortgages, car loans, student loans, credit cards, etc. - will require something closer to twenty eight trillion dollars to repay.
If you’re following along here, you might ask at this point, “where will the additional fourteen trillion dollars to repay those bank-created and loaned fourteen trillion in credit going to come from”? If all new dollars created by banks as loans require interest payments, must we continually take out new loans to pay the interest on old loans? Sounds like a pyramid scheme doesn’t it? Did you ever wonder why economists and politicians are always so concerned about “growth”?
If you happen to be a European Union member country, this problem of always needing to pay back more dollars (Euros in their case) than were originally loaned, has become very apparent. The European Central Bank (ECB) loans Euros (the European currency) to member countries at some interest rate. When the European Union was started a few years ago, member countries gave up their individual sovereign currencies and switched to the Euro. At that point, an exchange rate was determined, and in exchange for every Greek Drachma, or Italian Lira, or Spanish Peso, or French Franc, or German Deutsche Mark, etc., some finite number of Euros were provided to those countries. New Euros are now available only from the ECB as loans.
Think about that. Let’s say the population of Italy grows. With a given amount of Euros for a given number of people, when the population grows, either everyone will have equally fewer Euros, or some people will have many fewer Euros while others will have many more Euros. Remember, new Euros only come from the European Central Bank (ECB). If the population of Italy grows, the result will be either a decrease in the standard of living for all Italians, or inequality and increasing poverty within just a section of the Italian population. That is exactly what Italy and Spain are both facing now with 40% unemployment rates among their young people.
If the Italian government wants to stem that inequality and/or poverty, it must borrow more Euros from the ECB and find some way to evenly distribute those new Euros to their population. Yet every Euro borrowed requires more than one Euro to repay. Where do those additional Euros to pay for the interest on the loans come from? Remember Italy, like every other Eurozone country, started their Euro experiment with a fixed number of Euros. Every new Euro the Italians borrow from the ECB requires additional Euros to repay. Where do those additional Euros to pay for the interest on borrowed Euros come from? Is it any wonder that Europeans are questioning this entire Eurozone experiment?
You might ask, why, until recently, has Germany thought the Eurozone experiment is working well? Because of all the Eurozone countries, Germany is the largest exporter. (I personally know this because I’m trucking containers from Germany all over the southeast every week.) While most Eurozone countries trade only with other Eurozone countries, Germany manufactures many products that are purchased by countries outside of the Eurozone. That means they are paid in US Dollars for those products. US dollars are the currency of international trade. German companies being paid in US dollars will exchange those dollars at the ECB for new Euros which are then distributed to their employees and suppliers and then circulate throughout the German economy. As long as dollars are coming in, Germany never has to borrow Euros from the ECB to keep up with their population growth. Other Eurozone countries aren’t so fortunate because they are not net exporters.
The United States also has a central bank. We call it the “Federal Reserve”. The “Fed” loans US dollars not to states, but to the US banks under their auspices. While banks can simply create dollars via loans, as described above, the Federal Reserve is the watchdog for all banks using US dollars. The Fed has standards about how many “actual” US dollars a bank must have in “reserve” (just sitting there), in case a large number of depositors demand their money back, or too many lendees default on their loans. The Fed is also the clearinghouse for all financial transactions between banks. That’s why checks take overnight to “clear” - all inter-bank transactions run through the Fed. In fact, all banking transactions in US dollars, everywhere in the world, run through the Fed every night. That’s how we can “freeze” the accounts of Vladimir Putin and his friends, if those accounts are holding US dollars. The Fed also manages the world’s savings account for US dollars - treasury bills - the hole in the sand created when new dollars are created.
Unlike countries in the Eurozone, individual states in the US don’t have to “borrow” dollars from the Fed. Instead, US states get US dollars from federal spending, not from the central bank. Instead of having to repay those new dollars with interest, US states like South Carolina are simply GIVEN dollars from various federal government departments - transportation, education, agriculture, defense, etc. - ALL INTEREST FREE ! Greece, Italy and Spain can only dream about such a bonanza. All Euros those countries receive must be paid back with interest. THAT is what is causing all the financial problems in the Eurozone. Where do the additional Euros to pay the interest come from if all new Euros only come from the ECB? No one yet knows.
So you might ask, “where does the US Federal Government get THEIR dollars from”? Most people think the IRS simply collects OUR dollars which the federal government then spends. Remember that from a little kid’s perspective, our parents were never children. And for thousands of years we thought the earth was the center of the cosmos. From our perspective, we think the federal government operates a budget just like we do. It seems obvious that the federal government gets their “income” as taxes from us. When they don’t get enough income from taxes (when they have a “deficit”), they must “borrow” dollars just like we do if they want to “spend”. And the total of that borrowing is the federal “debt”, just like we have debt for our houses, cars and credit cards.
We are not children anymore. Let’s abandon this final myth.
Recall the hole in the sand and the bucket holding the sand. The federal government uses double-entry bookkeeping, just like banks. And just like banks, the federal government via the treasury department, can “credit” as many dollars as they need as long as they also create a debit for those dollars - they dig a hole in the sand creating the debit, and fill the bucket with the credit - new dollars. That process is called “federal spending”. New dollars are created when the federal government deposits dollars into a bank account - pay checks for federal employees, grants to federally funded research (which was my situation in 2012 which was when I first got curious about where that $100k grant came from), paying for new cruise missiles, social security checks, payroll for the Army, keeping national parks open, etc. Every new payment is new dollars put into the economy, which also creates an equal and opposite “debit” because of double-entry bookkeeping. The hole in the sand must equal the sand in the bucket.
Any issuer of a sovereign currency can create as much of their currency as they want. People generally say “print money” to describe this process. But actual cash dollars are a very tiny fraction of the total number of US dollars in existence. The vast majority of new US dollars are created as keystrokes crediting someone’s bank account - not cash. How many US dollars has the federal government created? Simply measure the size of the hole they came out of. We call that hole the “US debt”. Today the hole in the sand is nearly $18 Trillion dollars. So there are $18 Trillion dollars in the world economy which don’t require repayment plus interest. There are about $14 Trillion that have been created by banks that will require interest payments to clear the debt. Which dollars would you rather have, interest free dollars from federal spending or debt-created dollars which require even more dollars to pay back?
Over the past few months the federal government has substantially reduced the “deficit” - they’ve collected enough federal taxes to nearly pay for the ongoing federal spending. What does that mean for the average American? Every month fewer dollars remain in the economy. If we actually “balance the budget”, no new dollars will be put into the economy - by the end of the year the sand in the bucket will be poured back into the hole in the sand. If our population decreased, if our productivity increased, if everyone was fully employed, and everyone was living a more simple life, that might not be a problem, in fact it might be required to keep price inflation in control.
But our real unemployment level is something above 10%, perhaps 40% of our population is “underemployed”, our productivity increases have just about topped out, our population continues to grow, and a consumer-driven lifestyle seems to have obsessed the majority of Americans. If more dollars aren’t put into the economy every year, either we will all equally have fewer dollars at the end of the year, or some of us will have a lot fewer dollars at the end of the year while some people are still doing well or even doing better.
If we were to actually try to “pay down the debt” - the $18 Trillion total of all the holes in the sand from the previous two hundred years of federal spending, that would mean we would have to pull more dollars out of the economy - reduce the sand in the bucket and use it to fill all the holes in the beach. If we suffered a cataclysmic disaster that wiped out half our population, that would probably be required to keep price inflation from getting out of hand. But if our population continues to grow, we will have to continue feeding more dollars into that population via federal spending or suffer from worsening income and wealth inequality.
The federal debt isn’t a problem. It is simply the measure of how many cumulative dollars the federal government has put into the economy. As long as we want dollars in the economy that don’t require us to “pay back” those dollars with interest, the debt isn’t a problem. As long as we want the federal government to provide critical services like defense, a social safety net and last-ditch medical care, the debt isn’t a problem. And as long as the federal government continues to use double-entry bookkeeping, we will have a federal “debt” equal in size to the number of dollars the federal government has spent into the economy over the previous two hundred years. The US federal debt isn’t a problem. Just ask a Eurozone country.
The federal deficit also isn’t a problem. The federal deficit is simply the measure of how many new dollars created through federal spending are left in the economy every year. If our population is growing, our unemployment is dropping, our savings are growing, and people want to increase their quality of life, more dollars must be put into the economy every year or there won’t be enough dollars to fund all that growth.
The only problem we have with debt and the deficit is how we’ve interpreted the world from our own limited set of experiences and our personal points of view. As we’ve become wiser we’ve come to understand that our parents were once children with parents of their own. We all now agree that the earth is NOT the center of the universe. It’s time we all recognized that our federal monetary system doesn’t work like our household budgets. Federal taxes are not like our personal incomes. Federal taxes do NOT fund federal spending. And the US federal “debt” is not like our personal “debts”. Those negative dollars are simply the hole in the sand that is circulating throughout the world economy.
The world doesn’t work the way we think it does and it is upsetting to recognize reality. But if we all embrace this reality we can stop nearly all the deadlock in Washington, and end the decades of needless suffering and wasted lives that our misunderstanding has been forcing on many millions of Americans.