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Civility is the ability to disagree with others while respecting their sincerity and decency. Civility begins with understanding. We can best understand our political differences by first understanding the moral foundations upon which political views are built. This site features research, resources, and commentary related to the pursuit of Civility through understanding.
 

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens… The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

John Maynard Keynes, 1919

 

Government has a bottomless piggy bank, and it’s us.  We just don’t realize it.

Keynes was referring to inflation of the money supply.  In simple terms the money supply is the total of everyone’s physical money plus everyone’s bank accounts.   Government can increase or decrease the total supply of money through actions of the Federal Reserve (Fed).  In fact, one of the Fed’s main functions is to regulate the money supply, this is called monetary policy.

When government increases the supply of money, the money already in circulation is automatically worth less.   It’s much like shares of stock.  If you own 100 shares of a company that has 1000 shares outstanding, you own 10% of the company.  If the company was able to issue 1000 new shares, your 100 shares would now own just 5% of the company.  This kind of action in a company’s stock is called dilution.   When it happens to money it’s called inflation.  Same effect.  Whenever new stock/money is created, the value of existing stock/money is now lower.

Let’s look at it another way.  We all know that when lots of people want something, the price goes up.  For example, you may wish to purchase a new car.  You have the money.  You know the price should be $15,000.  Then, just before you go to buy the car, the government announces they will give everyone who doesn’t have a car $20,000 to buy a car with.  Suddenly lots of people have access to the cash needed to buy a car.  Guess what the dealer does to the price?   At first your $15,000 was valuable enough to by a car, but after the government increased the supply of money available to buy cars, your $15,000 was no longer valuable enough to afford the car.   So (the government program) increasing the  supply of money  made the value of (your) existing money lower.

At any given time you own a certain percentage of the money supply.  When government increases the money supply, the value of your money is lower.  But since your bank account didn’t change, you wouldn’t have any way of knowing.

How would you become aware you now own a smaller percentage of the money supply?   When money is created,  more dollars are chasing the same amount of things to buy, causing prices to rise.  This rise in prices is how we measure the effect of increasing the money supply, so over time the rise in prices has come to be referred to as inflation.  The Consumer Price Index (CPI) is our most common measuring stick for inflation.  Because the economy is so large and complicated, it is impossible to know which prices will rise, when they will rise, or by how much they will rise when the money supply is increased.

So, whenever governement increases the money supply, it is eventually ”paid for” by an increase in the price of something, at some time.

How does government increase the money supply?  For reasons too complex to explain here, the Fed mainly controls the money supply by setting interest rates.  The Fed can also directly create dollars.  It creates new dollars by simply increasing the total in it’s own bank account.  If you’re unfamiliar with this it may sound incredible, but that is actually what happens.  The Fed can create money and use it to buy anything it wants.

One of the Feds favorite things to buy is Treasury Bonds.  The sale of Treasury Bonds is how the U.S. government finances it’s deficit spending.  When the government needs to borrow it announces a sale (the term they use is auction) of T-Bonds.  Guess who buys the T-Bonds?  The Fed.  Where did the Fed get the money?  They created it.  The Fed is by far the largest holder of US government debt, usually holding about 50% of the total.

This is called “monetizing the debt“.  If you’re the government and you’re short of cash, it is much quicker and easier than raising taxes or borrowing from the Chinese.

Monetizing the debt means (since the government inflated the money supply) we will eventually pay for it in inflated prices. And since the Fed is independent, they don’t have to tell anyone what they have done, what they are doing, or what they intend to do.   This is what Keynes is talking about when he says governments can confiscate the wealth of their citizens secretly and unobserved, and why not one man in a million can diagnose it.

Is there any limit to how much money the Fed can create?  Yes, it’s just that no one (including the Fed) knows what that limit is, because it’s just too complicated.  They know if they create too much money, inflation will increase.  If they create way too much money, they will lose control and money will hyper-inflate causing disruptions in society (imagine prices rising 50% or greater every year, which has happened many times in world history, and some voices believe can happen again in the U.S.).  This is why the Fed always says their main job is to fight inflation.  The Fed believes it can manage the money supply any way it wants, as long as it controls inflation.  So in practice, the inflation rate is the main limit on how much money they will create.

An inflation rate of 1-3% is, A) low enough that citizens won’t notice, and B) low enough the Fed doesn’t think it will lose control.  An inflation rate of say 10% is high enough citizens will notice and the Fed will fear losing control.

How did we get into this situation?  At the turn of the century economists developed theories that by managing the money supply they could control the business cycle, meaning they would prevent down cycles and keep the economy in a permanent semi-boom cycle, which would feature near full employment.   Especially after the Great Depression, this sounded mighty good.  And so, the last 100 years has been a living experiment.  All the booms and busts, including the one we are experiencing now, have been the result of the unforseen consequences of various interventions in the economy by government.

Likewise, no one knows what would have happened if the government had not been intervening.  And that is the battle line in the debate between (so called) Keynsian economists and ‘free market’ economists.  Stay tuned.

 

 

UPDATE:  A reader posted this article to reddit.com, generating extensive comments.  See the full thread here.

A more technical (and scarier) description is provided here by zerohedge.com.

 

 

 

  2 Responses to “How Government Funds Itself”

  1. [...] The real threat is not the collapse of financial institutions, but the threat of governments stepping in to resuce so called “to big to fail” insitutions.   Governments don’t have the money, so they will print it up via the central banks.  This will certainly lead to inflation, and perhaps hyper-inflation. [...]

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