This is the third and final blog in a series I have done on the topics of the federal debt/deficit and why money in modern economies has value. I covered a lot of ground in the previous two blog entries.

In the first, which you can read here, I explained why politicians and some economists were wrong to throw up barriers to raising the deficit and the national debt in times when the economy is operating well below capacity, particularly in the years immediately following the Great Recession of 2007-2009.

In the second, which you can read here, I focused on the fact that taxation is what gives value to money that is not backed by something tangible like silver and gold (fiat currency).

The National Debt is Essential

To pause for a conclusion here, I want to emphasize that the national debt is actually essential to a modern economy. Every dollar that you have in your possession is a dollar that the US government has spent into existence and has not yet taxed. But that means it is federal debt, by definition.

So, all the savings that you and everybody else has, denominated in dollars, adds up to the national debt. Talk of eliminating the national debt is not only misguided, it is entirely foolish, because if we did that, all the savings you and everybody else had (denominated in dollars) would simply vanish! Those dollars in your wallet – checking account, or wherever – whoosh, gone instantly. There would be no modern monetary economy at all.

Okay, So Why Borrow to Finance the Deficit?

So if government spending exceeds the amount taken in by way of taxation, why does the government have to finance the cumulative difference (the debt) by selling bonds? Wouldn’t it be less stressful if we did not owe all that money to China or pension funds or to banks or to anyone? Why not just spend the money into existence without borrowing it?

Well probably the most obvious answer to these questions is that many of the ways that government officials and even economists think about money is a holdover from the gold standard era. Back then, governments were truly limited in what they could spend based on how much gold they had in reserve, because people could literally exchange their currency for government gold. In order to prevent people from doing this to the point that it ran out of gold reserves, a government would “soak up” extra currency by selling bonds to finance its debt. This would take currency out of the system for the time being with a promise to pay in the future, when presumably, there would be more gold on hand or the value of the currency would change.

But this is not necessary now because no one has the right to obtain government gold for their currency, since the gold standard is long gone everywhere.

But there is another, more practical reason the government finances its debt by selling bonds – and that is to create a market for them for the express purpose of manipulating interest rates.

Fractional Reserve Banking

When you deposit your money in the bank, that bank does not put your money in a safe and wait for you to come and retrieve it. The bank loans it out. But banks cannot lend out all the money they have on deposit, or they would be broke. They are required to maintain a fraction (about 10%) on hand. This number is called the reserve requirement ratio. Let’s say that at the end of a certain day, a bank is short on its reserve requirement. What should it do?

The first thing it does is consult other banks, because some of them may be over their reserve requirement. In this case the bank that is below would obtain an “overnight loan” from the bank that is above. The interest rate the bank pays on the loan is the overnight loan rate, also known as the “federal funds rate.” Its value fluctuates daily and you can easily obtain its current value by an Internet search. Many interest rates that you pay, including mortgage rates for a home or for a loan on a car, are related to the federal funds rate. So it is a very important item!

Where Bonds Come In

In the presence of a federal bond market, the US government, or its monetary representative the Federal Reserve, can influence the value of the federal funds rate by selling bonds (which takes money out of the system, raising rates) or by purchasing them (which puts money into the system, lowering rates). Normally, these practices are called “open market operations.”

Remember all the quantitative easing policies: QE1, QE2 and QE3? These were unprecedented levels of open market operations of Federal Reserve purchasing of bonds (and other assets before QE3 ended). These policies were undertaken to keep interest rates very low in order to stimulate the economy (making it easier for people to borrow to finance business loans, mortgages, auto loans).

Without the bond market, the federal government would not have that kind of control over interest rates. Some economists have argued that this would be a good thing. Some argue that the result would be a federal funds rate of zero permanently. Some claim that this in turn might very well lead to runaway inflation. But then again, many critics argued that the increasing government debt and quantitative easing would lead to hyperinflation – and that did not happen. However, we will probably never know because it does not seem realistic at the present moment to believe that the government of the US or any other entity that issues its own currency will ever give up the practice of issuing bonds to finance its debts. And, as I think I have shown in this series, there are bigger fish to fry than debating whether or not to abandon bonds.

Tom Blaine is an Associate Professor for OSU Extension.