Chris in North Carolina has been wondering: when the government prints up new money, where does it go? Rod in Texas wants to know: how long can the government keep spending money it doesn't have — before it has to shut down?
Can you explain what the government does when it prints money? How does it put that new money into circulation? Is all new money just replacing old money? How can money be introduced without somebody getting a lot of cash for nothing?
— Chris, Raleigh, N.C.
To start off, you have to make a distinction here between “cash” (which takes many forms, including checks, advances on your credit card and electronic transfers) and physical currency — the paper or coins used to represent cash in a financial transaction.
U.S. paper currency is technically a Federal Reserve note, printed by Bureau of Engraving and Printing. Most of the notes are printed to replace damaged currency that is taken out of circulation and destroyed. A dollar bill has a life span of less than two years, for example, while a $100 bill lasts, on average, more than seven years. There is about $750 billion in U.S. currency in circulation; the Fed estimates that most of it is outside the United States.
Within the U.S. the Federal Reserve is in charge of making sure banks keep their ATM machines stocked with enough cash to meet the public’s demand for paper notes. And that demand rises and falls over time. People need more cash at this time of year, for example, to hit all those post-holiday sales. There’s more cash in circulation on the weekends — when people go to the mall or out to restaurants and movies — than there is during the week.
If demand for cash rises, banks go the Fed and ask for more paper notes, and the amount is deducted from the banks’ “cash reserves.” All banks are required to carry a certain minimum amount of “cash” on their books - called reserves - to meet demand from depositors who want to withdraw funds. Those withdrawals can be paid with a check, electronic transfer or with paper currency. When banks have more paper money than they need, they send it back to the Fed. The amount is then added to the banks’ “cash reserves.” (In effect, the pieces of paper are replaced with electronic bits in the bank's computer system.)
The Fed also controls the size of the “money supply” — which is a bit different than the amount of currency in circulation. There are several different measures of the money supply, starting with physical currency and reserves. (Other measures add in checking and savings deposits, money market accounts, CDs and other forms of “cash.”) When the Federal Reserve decides to boost the money supply, it buys Treasury bonds on the open market. The cash it pays to the sellers of those bonds (almost all of which take the form of electronic bits) goes into the banking system. The Fed doesn’t just hand that cash over to a bank; it makes it available to a bank to lend.
Loans have the effect of creating cash: If you borrow cash from your credit card, that cash gets spent as easily as if you have cashed a paycheck. So when the Fed encourages more lending (which it also does by cutting interest rates) it puts more money in private hands, which typically increases economic activity.
On the other hand, if the Fed thinks there’s too much “money” sloshing around (a situation that can fuel inflation) it will sell some of its Treasury bonds, taking cash away from buyers of those bonds, and mopping up some of the cash in the system in the process. It can also raise short-term interest rates, which make it more expensive for all of us to borrow. That (usually) also slows down the economy.
How can any government continue to operate at a financial deficit? At what point does this deficit prevent government from operating?
— Rod, Houston
In the short term, the only obstacle is the official debt ceiling, which is the statutory limit on total federal borrowing. The problem is that the debt ceiling is set by Congress — the same folks with the spending problems that created budget deficits in the first place.
This is roughly the same as letting you or me decide how big a limit we’d like on our credit cards. Before you went to the mall, you’d just call up your credit card company and tell them you’d like to raise your limit, and they'd automatically say yes. Of course, no lender in their right mind would agree to such an arrangement. (For everything else, there’s the U.S. Congress.)
There are always some members of Congress who don’t like this arrangement. From time to time, when the government is about to run out of money and needs a bigger credit limit, there are some in Congress who threaten to shut down the government as a form of protest. You can usually find them on C-SPAN speaking eloquently to an empty chamber.
Occasionally, someone in these standoffs forgets to blink and the government actually does shut down — sort of. The last time this happened, there was a partial shutdown — for six days in November 1995 and again for about three weeks beginning in December 1996.
Some 760,000 federal workers were either laid off or kept working with a promise they’d get paid later. Passports weren’t issued, visitors to national parks were turned away, and clean-up of toxic waste sites was halted. In the end, the Clinton White House and Republican Congress worked out a deal and things got back to normal.
It could happen again, but the move is so disruptive, Congress usually just raises the debt ceiling and keeps on spending. As of the end of November, the debt ceiling was $8.97 trillion, and the total national debt was about $8.55 trillion. Which means Congress has another $420 billion or so on its credit card before it gets a call from the Treasury saying it’s maxed out.
This house of cards will continue to stand as long as investors keep buying the IOUs (aka bonds) printed up by the Treasury Department and sold to investors. But if demand for those bonds slows down, the only way to sell more debt is to raise the interest rates paid out on those Treasury securities. When that happens, the higher cost of borrowing is a big drag on the economy. If it goes on for too long, you get a recession.
The problem is that this process plays out so gradually that, over the short term, it’s hard to point to the harm being caused. It’s a little like global warming: As long as there’s no immediate, dramatic impact, people figure we can go on this way forever. And as long as the U.S. economy remains strong, the borrowing is sustainable.
With the U.S. economy currently throwing off a solid flow of tax revenue, this would be a great time to get the federal budget beast under control — much the way a raise or a bonus at work is a great opportunity to pay off your credit cards. On the other hand, if we wait until the baby boomers retire, and the double-debt piles of Medicare and Social Security come due, it’s going to be a lot harder to deal with.