You Don’t Understand the Debt

So-called “fiscal responsibility” is one of the most enduring sacred cows of American politics. Politicians across the spectrum work hard to protect their image as sound fiscal stewards. Republicans have tried (and failed) to pass several balanced budget resolutions to ensure the Federal Government’s revenues match or exceed its expenditures. Obama promised to tighten our belts in the wake of the Global Financial Crisis so as not to burden future generations with suffocating tax liabilities. Even Bernie Sanders claims to be a fiscal conservative and concedes that tax increases would be required to fund social programs like Medicare for All and a Green New Deal. Austerity is deemed prudent while deficit spending is reckless. This isn’t just bad economics: it depends on a fundamental misunderstanding of what the National Debt actually is. Government debt is a financial asset of the non-governmental sector, not a liability. There is no need to ‘pay down’ the National Debt. Furthermore, taxes do not fund federal spending. Federal spending is logically prior to tax payment. These observations are synthesized in a growing body of work known as Modern Monetary Theory (MMT) which offers a rigorous anthropological and historical analysis of money in addition to a detailed look at the modern real-world operations of federal spending. Understanding MMT is crucial to thinking rationally about public policy.

It’s no surprise that most Americans have a dim view of debt. Debt is a chief source of anxiety in our personal lives. Car payments, student loans and mortgages threaten our financial and mental health. Depending on interest rates, paying down debt is often the best use of income for many households. This is the same logic most Americans apply when thinking about the National Debt: if paying down my personal debt is financially responsible, shouldn’t the Federal Government pay down its debt? The key mistake here is the failure to recognize that households and the Federal Government have entirely different relationships to currency. Households are currency users whereas the the Federal Government is the sovereign issuer of currency. Households issuing currency would be jailed for counterfeit. The importance of this distinction is bound up with the definition of government debt and fiat money.

What is Government Debt?

To better illustrate relationship between government debt and money, consider a brand-new government with no debt and a new economy with no fiat money in circulation. Let’s say the government wants to purchase some good or service (say $100 worth of sheep). At the same time, the government will impose a tax (say property tax) denominated in the unit of account of the currency it is issuing. This means the government will accept its issued currency as payment for the tax liability it imposes. The government then ‘prints’ $100 and exchanges the notes for sheep. The tax liability creates demand for the issued currency because individuals must pay the tax or face punitive measures by the state; generally imprisonment. The currency issue is thus accepted as payment for the sheep. The government comes to hold the $100 worth of sheep and the non-governmental sector comes to hold the $100 of currency.

This is the essence of deficit spending and fiat money creation. Immediately after the purchase, the government is $100 in ‘debt’ because it has spent $100 more than it has taxed back. The currency issued is accepted by other participants in the economy due to the demand created by the tax liability. The above example isn’t just a thought experiment- it’s exactly what American colonial governments did to move goods and services from the non-governmental to the governmental sector. Government spending is logically prior to taxation, and the debt incurred is equal to the net financial assets accumulated in the non-government sector. But wait- what did the colonial governments do with the taxes they collected? They burned them. Yes, burned. After all, the paper notes issued by the government are merely an IOU (I owe you); a promise to redeem for tax credit or other fines and fees. When the government issues a $1 bill in exchange for a good or service, it is saying I owe you $1 of tax credit. These IOUs are ‘redeemed’ on payment of taxes and the account is settled. Therefore, taxes do not fund spending, but rather spending makes tax payment possible.

A useful way to represent the above example is to show the balance sheets for the entities involved. For non-accountants, the balance sheet tracks the assets, liabilities, and net worth of an entity. The accounting equation is Assets = Liabilities + Net Worth. For simplicity, I will be using a two-sector model; governmental and non-governmental. The non-governmental sector is actually split into the foreign and domestic sector, but the accounting identities remain the same because the aggregate of the foreign and domestic sectors equals the total non-governmental sector. Here is the starting position of the above example with a fresh government and an individual with $100 worth of sheep:

Starting Position

Now, the government purchases $100 worth of sheep by issuing currency:

Government purchases $100 worth of sheep

And this is what a $40 tax payment (or more accurately, redemption) looks like:

$40 tax payment

So consolidating these transactions, the final balance sheet position looks like this:

Final position

As you can see, government debt is equal to the net financial assets of the individual.

Let’s return to households for a second. Warren Mosler, one of the progenitors of MMT, often describes an example of how a parent might use the same principles to get their kids to do chores. The parent purchases goods (or more likely services, such as a car wash or grass cutting) by issuing a ‘money token’ such as a business card. At the same time, the parent imposes a tax of two business cards every Saturday at 5pm. If a child fails to pay, they are sent to bed early with no dessert. The parent is the sole and sovereign issuer of business cards. Now the business cards have value and the child is willing to perform services to obtain them in order to avoid punishment. If there are multiple children, they may trade business cards among themselves for other goods and services or seek to accumulate them. Even if one of the children is tax-exempt, business cards are still valuable to them because the other children need them to meet their weekly tax liability and would be willing to accept them as payment. The business cards now function as fiat money. Notice that the parent, as the sovereign issuer of currency, can never run out of business cards and is not particularly concerned with the debt she incurs upon issue. There are reasons a currency issuer might wish to increase taxes or reduce spending, but inability to pay is not one of them.

Spending and Taxes in the Modern Economy

Even upon close inspection, it appears as though taxes fund government spending in the modern economy. Taxes are paid almost exclusively through checks on demand deposits at private banks that have accounts at the Federal Reserve. When you pay taxes, the bank debits your demand deposit and the Fed debits the bank’s reserve account. Simultaneously, the Federal Reserve credits the Treasury’s checking account at the Fed. This account is called the Treasury General Account (TGA). Here is some accounting background to keep things straight:

  • Demand Deposit: Asset of the individual, liability of private bank
  • Reserves: Asset of private bank and Treasury, liability of the Fed
  • Treasury Securities: Asset of private bank, liability of the Treasury
  • For ease of understanding, ‘debit’ will mean decrease and ‘credit’ will mean increase, as opposed to the typical accounting use of these terms (sorry accountants)

Paying taxes ultimately results in a debit to your demand deposit and credit to the reserve balance of the TGA, leading to a net loss of financial assets for the non-governmental sector. Federal expenditures involve a debit to the TGA and credit to demand deposits, resulting in a net gain of financial assets.

The Treasury and Fed coordinate to keep the TGA balance between $150 billion and about $400 billion depending on expected tax revenues for the day.

Treasury General Account Balance

By mandate of Congress, federal expenditures must be made from a positive TGA balance. The Fed cannot overdraw the TGA. To cover the difference between tax revenue and spending, the Treasury issues bonds on the ‘primary market’ to select banks. These bond auctions are underwritten by the Fed and cannot fail: the Fed will always ensure the success of the bond auction. Bond sales are realized as credits to the TGA, debits to the bank’s reserves and credits to the bank’s treasury account at the Fed. In practice, treasury bond accounts function as ‘savings’ accounts at the Federal Reserve whereas reserve accounts are ‘checking’ accounts (although since the Global Financial Crisis, reserves also earn a small amount of interest). This form of debt issuance via bond sales is referred to as government ‘borrowing’.

On first glance, it appears as though taxes and borrowing do indeed fund government spending. Taxes and bond proceeds flow through the TGA and federal disbursements must be made from a positive TGA balance. But wait- why must the TGA have a positive balance? Why does Congress mandate that the Treasury must cover deficit spending through bond issuance? Historically, the Treasury issued bonds to protect its gold supply. But the United States abandoned the gold standard in 1971, so this reasoning is obsolete. Another motivation behind the Congressional mandate was the idea that allowing the Fed to overdraw the TGA would somehow lead to runaway inflation. Examining the underlying operations reveals that this is also nonsensical. The Treasury creates bonds out of thin air and banks buy them with reserves on the primary market. From the bank’s perspective, this effectively means moving assets from ‘checking’ to ‘savings’ at the Fed. If the bank later prefers ‘checking’, it can sell its bonds to another bank or the Fed. The TGA receives a credit to its reserves on sale of the bond which allows it to make disbursements. Bond issuance to cover deficit spending still results in the creation of a net financial asset for the non-government sector because Treasury bonds are a liquid financial asset. What is a Treasury bond? Like currency, it is government debt created out of thin air.

Let’s quickly look at the balance sheet changes when the government deficit spends by issuing bonds. We will imagine the government is raising $1,000 to cover a Social Security payment. Keep in mind that the $1,000 must have first been spent into the economy by the government in order to be borrowed back. The purpose of this example is to show how bond issuance to cover expenditures still results in net financial asset gain for the non-government sector. First, the primary bond auction:

Treasury issues $1,000 in bonds

Now, the government pays $1,000 in Social Security benefits:

Government spends $1,000 in Social Security benefits

And consolidating to the final position:

Final Position

Notice that, like in the example of the brand-new economy, the government debt (treasuries) is equal to the net financial assets of the non-governmental sector. The sale of treasury securities to cover federal deficits still results in a net increase of $1,000 in demand deposits. The private bank holds the treasury securities as its (interest paying) asset, which it can swap for reserves at its leisure. Reserves can be redeemed for cash if the bank so chooses.

What about taxes? As discussed in the first section, currency must be spent into the economy before it can be taxed back. The government must first issue its IOUs in order to call them for redemption. Even in the modern economy where tax revenues appear to flow through the TGA, taxes do not fund spending. This illusion is created by Congress’ arbitrary mandate that the TGA must maintain a positive balance. In reality, the Fed merely functions as a scorekeeper to track transactions between entities that have accounts with it. As the sovereign issuer of currency, the government can never run out of ‘points’ to put on the board. MMT scholar L. Randall Wray often notes that the government spends by crediting bank accounts. That’s it. The mechanical operations that appear to link taxes, borrowing and spending are illusory products of political choice rather than necessity.

Why Have Taxes?

Given that taxes do not fund spending, why have any taxes at all? The primary purpose for taxes was discussed in the first section of this article. Taxes drive currency. Taxes, fees and fines create demand for the government’s IOUs. This fact is obscured by the maturity of the modern economy where dollars appear to function almost as commodities. Nobody consciously thinks about collecting dollars in order to meet their tax obligations. However, it is these very obligations that help currency get off the ground in the first place. The governments of colonial America certainly knew this. Historically, sovereigns have aggressively prosecuted tax avoidance even when currency took the form of specially cut sticks and branches. Why? The sovereign does not need more sticks. Rather, tax avoidance undermines the value of the currency and, therefore, the power of the sovereign.

The second function of taxes is related but much more pertinent to the modern economy. Because taxes decrease net financial assets of the non-governmental sector, taxes tend to reduce aggregate demand, and therefore inflation. Critics often claim MMT advocates for reckless money printing that would result in hyperinflation. Nothing could be further from the truth. MMT recognizes that government spending is not revenue constrained, but rather constrained by the real resources available in the economy. Too many dollars chasing too few resources leads to price increases and inflation. Taxes are one method of removing dollars from the economy and thus cooling inflation. Taxes are a counter-cyclical stabilizer; meaning tax revenue rises during economic expansion and falls during contraction, even when tax rates remain unchanged. Assuming government spending remains constant, falling tax revenue during a recession helps accommodate the savings desire of the private sector by reducing the drain on the private sector’s net financial assets. The other side of the accounting identity is the increase in the federal deficit.

Federal deficit before, during and after the financial crisis

Third, taxes can serve political purposes. ‘Sin’ taxes are imposed to discourage certain behaviors like smoking or the burning of fossil fuels. High taxes on the wealthy may be desirable because wealth accumulation undermines democracy via massive distortions of political power. None of these has anything to do with funding the government.

A Note on Money Creation in the Private Economy

Informed observes will point out that the money supply in the non-governmental sector is not equal to the National Debt. This is correct. The National Debt only represents the net financial assets of the non-governmental sector. Money is also created by banks in the private sector.

The conventional view of banking is that banks lend out their deposits and make profit off of the interest. When you put your money in the bank, the bank turns around and lends that money out. That is, banks depend on deposits in order to make loans.

MMT has long argued against the conventional view because it misrepresents how banks operate in the real world. In reality, loans create deposits and not the other way around. The MMT view was confirmed in a 2014 paper by the Bank of England. Banks create money by issuing loans. Consider what happens when you take out a $10,000 personal loan:

  • The bank creates a demand deposit for $10,000 which is your asset and the bank’s liability
  • The bank now has a contract for $10,000 which is your liability and the bank’s asset

Like all money, demand deposits created by banks are debt. They are just debt of private institutions. Rather than being redeemable for tax credit, demand deposits are redeemable for currency on demand. When you withdraw cash from an ATM, your demand deposit is debited. The same is true when you pay taxes.

If all private debt were settled or forgiven, there would be $0 in privately created dollar denominated financial wealth in the economy. The remaining money would be exactly equal to the National Debt. This is why government debt is a net financial asset of the non-governmental sector.

MMT Accounting Identity: Govt. Balance + Private Domestic Balance + Foreign Balance = 0

This framework helps explain why Quantitative Easing (QE) failed to generate inflation in the wake of the financial crisis. QE refers to the central bank practice of buying up the financial assets of private banks. The purpose of QE is to 1. increase the liquidity of banks and 2. flood the inter-bank market with reserves to drive down interest rates. Presumably, 2 will lead to more economic activity since money is cheap. Many ‘interest hawks’ during QE spread fear that near-zero interest rates and the massive influx of reserves would lead to hyperinflation because the Fed was just ‘printing money’. Of course, this did not happen. In fact, the Fed actually struggled to generate inflation; meeting or exceeding its 2% target in only two of six years from 2009 to 2014. But why?

US Inflation 2000–2019

The answer is that bank lending is not reserve constrained, but rather determined by a myriad of other factors. Even interest rates have little bearing on economic activity and the decision-making process of firms. Reserves are ‘stuck’ in the inter-bank market. Unlike demand deposits, they aren’t used to purchase goods and services in the real economy. There is some evidence that QE did lead to an increase in the amount of demand deposits, but this primarily resulted from banks buying financial assets (bonds, etc) off other entities before turning around and selling them to the Fed. These deposits are far less likely to be spent back into the private economy than deposits created by wages or government spending on social programs. The Bank of Japan has maintained a zero interest rate policy for over twenty years and consistently fails to generate inflation.


For decades we have been told vital social programs are simply untenable because we cannot afford them. MMT exposes the affordability argument as a dangerous falsehood. Take the debate over Social Security funding as a microcosm of this fiscal insanity. Democrats propose raising the retirement age or increasing the payroll tax to ensure the “sustainability”. Republicans propose privatizing the whole thing and leaving the fate of the elderly to the whims of the financial markets. But watch former Fed chair Alan Greenspan’s answer to Paul Ryan’s question about the sustainability of Social Security:

In case you missed it, here’s the direct quote from Greenspan

There’s nothing to prevent the Federal Government from creating as much money as it wants and paying it to somebody. The question is, how do you set up a system which ensures the real assets are created which those benefits are employed to purchase?

This is exactly what MMT shows. The questions relevant to government spending are about inflation, employment and social welfare; not affordability. The primary concern is developing and allocating real assets and labor in the economy. The government can always afford to buy what is available for sale.

What about Medicare for All? It’s entirely possible that Medicare for All would indicate a tax cut- at least in the short-run. Why? Because Medicare for All would eliminate an entire segment of the insurance industry, which would be a highly deflationary event. Billions of dollars of income and spending would be wiped out. This is not necessarily a bad thing as there is a strong argument that the medical insurance industry is a net drain on society. But it would require an appropriate macroeconomic response by the government in order to soften the blow to aggregate demand.

MMT helps us think more clearly about which taxes are good and bad. Many MMT scholars regard payroll (FICA) taxes as a bad tax because payroll taxes are regressive and disproportionately burden the lowest earners. The current orthodoxy maintains that payroll taxes fund Medicare and Social Security. Once MMT dispels the myth that taxes actually ‘fund’ anything (much less specific programs), it is much easier to decide which taxes to keep and which to dispense with. For example, MMT scholars also regard (hold on to your seats progressives) corporate taxes as a bad tax because corporations are able to avoid these taxes through accounting manipulation and typically pass costs onto consumers. It’s far more effective to tax the owners of wealth directly rather than attempting to tax such a complex entity.

What MMT shows us is not that deficits don’t matter, but that they matter for very different reasons than personal debt. Aiming for a balanced budget is totally arbitrary and potentially destructive. This is especially true in a country like the United States where the domestic sector runs a large trade deficit with the foreign sector. There’s nothing wrong with trade deficits, but they do drain the financial assets of the sector that runs them. Any government pursuing a budget surplus while the domestic sector runs a current account deficit is asking for a recession. This principle is why net exporters like Germany are able to run budget surpluses while still accommodating the savings desires of the domestic sector.

Finally, not all governmental entities are free of revenue constraints. Like households, state and local governments are currency users; not issuers. EU member states are also currency users because they cannot issue sovereign currency. These governments must either raise tax revenue or issue bonds to fund spending. They also tend to pay higher interest rates because there is no guarantee they will be able to service their debt obligations (see: Greece, Puerto Rico).

I’ve only covered the basics of MMT, but I hope this piece will add some clarity to the debate over public policy and spending. The national obsession over deficits is an understandable but misguided carryover from our personal experience with debt. We are having all the wrong arguments about how to achieve the social goals we desire because the austere conception of fiscal responsibility still looms large in the American consciousness. Changing the terms of the debate requires a fundamental shift in our understanding of debt to one that reflects how debt operates in the real world rather than relying on our own fears and prejudices.

Further Reading:

Macroeconomics (textbook) — Mitchell, Wray

Modern Money Theory Primer — Wray

Soft Currency Economics — Mosler

New Economic Perspectives — Blog run by Stephanie Kelton, Ph. D, various contributors

Bill Mitchell — Modern Monetary Theory — Blog run by Bill Mitchell, Ph. D

Academic publications by Eric Tymoigne, Scott Fullwiler, L. Randall Wray, Stephanie Kelton, Bill Mitchell, Warren Mosler and other affiliated economists.

Corporate accountant and former auditor with degrees in philosophy and accounting.

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