Originally Posted by
Danke
From the Chicago Federal Reserve:
A Money Creation Function
Debt does more than simply transfer idle funds to where they can be put to use -- merely reshuffling existing funds in the form of credit. It also provides a means of creating entirely new funds -- funds needed to finance the greater volume of new projects and spending that contribute to economic growth.
Again, checkable deposits in commercial banks and savings institutions are debts -- liabilities of these depository institutions to their depositors.
But checkable deposits are also the money used for most expenditures.
How do these deposit liabilities arise?
For an individual institution, they arise typically when a depositor brings in currency or checks drawn on other institutions. The depositor's balance rises, but the currency he or she holds or the deposits someone else holds are reduced a corresponding amount. The public's total money supply is not changed. But a depositor's balance also rises when the depository institution extends credit -- either by granting a loan to or buying securities from the depositor. In exchange for the note or security, the lending or investing institution credits the depositor's account or gives a check that can be deposited at yet another depository institution. In this case, no one else
loses a deposit. The total of currency and checkable deposits -- the money supply -- is increased. New money has been brought into existence by expansion of depository institution credit. Such newly created funds are in addition to funds that all financial institutions provide in their operations as intermediaries between savers and users of savings.
But individual depository institutions cannot expand credit and create deposits without limit. Furthermore, most of the deposits they create are soon transferred to other institutions. A deposit created through lending is a debt that has to be paid on demand of the depositor, just the same as the debt arising from a customer's deposit of checks or currency in a bank. By writing checks, the borrower can spend the deposit acquired by borrowing.
The recipients of these checks deposit them in their depository institutions. In turn, these checks are presented for payment to the institution on which
they are drawn. As a result, the newly created deposit can be shifted out of the originating institution, but it remains part of the money supply until the
debt is repaid.
No effort is made here to give a detailed explanation of the creation of money through the expansion of deposits and depository institution credit.
For present purposes, it is enough to point out that these institutions can make additional loans and investments, and thereby increase checkable deposit money, to the extent that they have the required amount of reserves against the increased deposits. The amount of reserves, in turn, is controlled by the Federal Reserve System -- the central bank of the United
States.
. . . a stimulus to growth
The chart: Debt and Economic Activity in the U.S. shows the general relationship between long-term trends in total debt and the value of the nation's production of goods and services, as measured by gross domestic
product. These measures generally have moved upward since the turn of the century, but neither has grown steadily. Both debt and production have made major upswings in wartime, but the only period in which there was significant liquidation of debt was in the depressed 1930s.
People are generally more willing to incur debt -- to buy houses and other big-ticket consumer goods -- when incomes and employment are rising.
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The principal danger of overall growth in debt is that new money created through the expansion of depository institution credit will touch off price inflation by stimulating too much spending. Over time, a moderately rising money supply is usually consistent with a rising level of economic activity and full employment for a growing population. Some expansion in debt and money is necessary for the full use of resources and satisfactory
economic growth. But when the economy is already working at capacity, or near that, additional money injected into the spending stream may simply drive prices up, setting the stage for subsequent recession and
unemployment. The Federal Reserve System is responsible for providing enough reserves to support reasonable credit needs, but to avoid expansion
at a rate that would cause price inflation and the subsequent economic problems.
Cyclical variations in private expenditures and private debt are offset to some extent by concurrent changes in public debt -- especially federal debt. In recessions, when the growth of private debt slows or declines,U.S. government debt usually rises, due partly to increased expenditures connected with programs to combat the recession and partly to reduced tax collections. Under such circumstances, increased public debt is not usually
an inflationary threat, but rather a reflection of the weakness of demand in the private sector. However, when the U.S. government is already borrowing to finance large deficits, any additional borrowing can raise
interest rates and further restrain economic recovery.
In periods of prosperity, private debt tends to grow more rapidly. At such times, higher incomes can be expected to bring tax receipts more in line with government spending, thus reducing the rate of growth of government debt or reducing the need for further borrowing completely.When personal and business credit demands are especially strong, with private debt increasing rapidly and prices tending to rise, the government should operate with a surplus and reduce federal debt.
Potential inflation then, not insolvency, is the principal danger associated with public debt. Given its extensive powers to tax and create money, the federal government can always meet its interest obligations, refinance
maturing securities, and even, when consistent with overall economic objectives as well as social and political choices, reduce its level of total indebtedness.
The Burden of Debt
The burden of debt has been given a lot of attention through the years. Yet the nature of the debt burden is still not clear. People can think of their indebtedness as a twofold burden -- the debt must be paid at maturity and
interest charges must be paid on schedule. Repayment may turn out to be burdensome either because income falls short of expectations or because the product or service purchased with the borrowed funds is less rewarding than expected (which, of course, could be equally true of cash purchases). The uncertainty of whether the benefits will eventually outweigh the costs contributes heavily to the idea that debt involves a burden.
What about the burden of the federal debt? As the economy grows, the total amount of public debt will probably continue to increase. Existing debt will be refinanced over and over again, and it will always be owned by those who want to hold government securities among their financial assets. The problem, therefore, centers largely on interest payments. But again, burden is hard to define.
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