Submitted by Taps Coogan on the 11th of September 2019 to The Sounding Line.

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When people visualize bank lending, they often think of banks taking savers’ deposits and lending them out to borrowers. This is, however, not how our fractional reserve banking system actually works. In reality, banks do not lend out savers’ deposits. When a bank creates a loan, they create money that did not previously exist. A bank needs deposits simply because deposits govern how much money banks can legally create and lend to borrowers.

Bank lending adds to the amount of money in the economy and allows people to buy goods or services that they could not otherwise afford, while simultaneously not limiting savers’ ability to do the same. That is why, when the growth rate of bank lending outstrips the supply of goods and services in the economy, inflation increases.

A bond is very different from a bank loan. When the federal government needs to borrow money, it does not secure a loan from a bank. Instead, the government issues a bond. When the government issues a bond, someone must purchase that bond. Whether that person is an investor, a commercial bank, or anyone other than a central bank, they cannot create money in order to purchase that bond (generally speaking). Bonds are purchased with existing money and do not result in the creation of new money. A bond simply represents a transfer money (and the potential for consumption) from someone to someone else.

Today, the idea that government deficit spending is stimulative for the economy is universally accepted as true. However, it is only true under very specific circumstances. That is because government deficit spending is financed with bonds which simply transfer the potential for spending from someone to someone else. Government bonds are either funded by reducing bank deposits and thus the potential for bank lending, or they represent money that would otherwise have been invested in, and spent by, the private sector.

There are two scenarios when government deficits can be stimulative. Neither of them apply today.

First, if during an acute recession, banks are not lending, savers are not investing, and the money supply is shrinking, government spending can represent spending that would otherwise not have occurred. This is clearly not the environment today.

Second, if central banks directly monetize government bonds, the monetized bonds add to the money supply and generally act like a bank loan. However, the Federal Reserve (America’s central bank) is not currently expanding its balance sheet and is not monetizing a particularly large portion of current deficits.

Unless the Federal Reserve restarts QE in a big way, today’s swelling government deficits are not increasing overall spending in the economy. Government deficits are simply transferring working capital away from the productive private sector and into the unproductive public sector. Lest one thinks that the Federal Reserve should therefore start expanding its balance sheet again and monetize more of the federal deficit, the entire structure of modern central banking was developed to avoid that situation. Why? The reasons to do QE today would have little to do with a need for economic stimulus and everything to do with masking the ill effects of unsustainable deficits. Every-time throughout history when government deficits have been monetized because they were too big, it has led to destructive inflation.

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