The Basics of How Macroeconomics Work

What is Macroeconomics?

There are A LOT of people who do not understand macroeconomics. Most members of Congress don’t. We the people, and our elected officials are discussing the economy in terms that are not real, not accurate. Our political leaders are implementing laws that are economically harmful.

This blog is a small bit of the effort to fix this.

Modern economies have the following attributes:

  • A fiat currency, which is not backed by any commodity such as gold or silver.
  • A floating exchange rate relative to other currencies.
  • A credit expansion banking system in which banks create and destroy money, by making and later retiring, loans.

There are reasons for all of the above, which we’ll get to soon.

Please allow me to walk you through a model of the economy that describes how it really works.

Important idea #1: Surpluses and deficits

Every dollar in income was spent by someone else

Every time one person receives a dollar in income, it can only be because someone else spent a dollar. It can not be any other way.

In order to have a dollar, it must first have been given to you

Anyone who has dollars in the form of cash in their pockets, money in their checking account, money in a savings account, money in a certificate of deposit, etc, MUST have previously received that dollar as some form of payment.

Surpluses and deficits

In economics, the term “surplus” is the amount by which one pile of money gets larger, and the term “deficit” is the amount by which another pile gets smaller.

If you and I each have $100, and I pay you $10 for something, I incur a deficit of $10 while you incur a surplus of $10.

Every surplus has a corresponding deficit

This is just another way of saying that in order for one person to receive a dollar, another person had to spend it.

The money we hold is a surplus

In aggregate, the holders of US dollars hold around $22T US dollars. In other words, there is an aggregate global surplus of $22T US dollars.

Every surplus has a corresponding deficit

If there is an aggregate surplus of $22T US dollars being held by various people in the world, where is the corresponding $22T deficit?

Hold that thought while we move onto important idea #2.

Important idea #2: US dollars

Where do US dollars come from? To be clear, I’m not asking where YOU get them from, I’m asking how is it that they exist?

250 years ago there was no United States, and hence there were no US dollars.

Today, there are about $22T US dollars in existence.

Where did they come from?

Important idea #3: Currency ISSUER vs USERS

In any economy, there is ONE currency issuer and many currency users.

The currency users live by the rules we are familiar with. Being responsible requires earning before you spend and spending within your means.

But, to get back to two important prior questions:

  • Where did the money we currency users use come from?
  • What deficits correspond to our collective aggregate surplus?

SPOILER: Those are two different forms of the same question.

Why Are So Many of Us Confused About This?

Because we confuse how USERS of the currency are constrained with how the ISSUER of the currency is constrained.

You, me, every business, every non-profit, and every level of government that is not the federal government are USERS of the currency. For us, we must obtain dollars before we spend them. If we spend more than we have, we need to borrow. We incur debt.

The US federal government is the ISSUER of the currency. Everybody else is a user of the currency.

How do currency issuers operate?

Most people hold two contradictory beliefs about money:

  1. The US federal government is the issuer of US dollars.
  2. The US federal government needs to obtain US dollars, in the form of taxes, before they can spend money.

But if both the above statements are true, where did the first dollar come from? How could it be taxed by the federal government before the federal government issued it into existence?

The answer is, item 2 above, is false.

Currency issuers literally spend money into existence and tax money out of existence. Literally.

In order for the federal government to collect money in the form of taxes, it must have first spent that money into the economy.

So, the National Debt is NOT actually debt?

When US federal government spends more money into existence than they tax out of existence, the difference is not debt, but rather the money we USERS of the currency use.

It is, in fact, the money supply (it’s more complicated than that because commercial banks also loan money into existence, sort of, but let’s keep the model simply for now).

The reason we are misled into thinking it is debt seems to be:

  • If we USERS of the currency spent more than we took it, it WOULD be debt.
  • After the US federal government spends money into existence, it offers people the chance to buy Treasury Bonds. When people do this, they are converting one form of money (currency) into another (treasury bills). Treasury bills are bonds on which the US federal government pays interest. If they’re paying interest, it must be debt? Right? After all, interest is what WE pay for the money we borrow.
    • What’s missing from the above idea is that when YOU move money from a zero interest checking account into an interest bearing savings account, you are not making a loan to the bank, in spite of the fact that they pay you interest.
    • When someone who has big bucks on deposit at the Federal Reserve (which is where the banks bank) moves money from a zero interest reserve (checking) account into an interest bearing treasury (savings account), they are no loaning that government to the Federal Reserve, in spite of the fact that they’re paid interest.

Can the US Federal Government Spend Endlessly?

No. The US federal government is constrained in its ability to spend. They are constrained by the productive capacity of the economy.

To use a famous line from the 2016 presidential election, Hillary Clinton said the US government could give everyone a pony, but how would we pay for it?

However, the issue is not the cost of ponies, but the availability of ponies. The US government COULD provide everyone a pony if we bred enough ponies. However, since ponies are not a national priority, this is not going to happen.

WTF? Can You Backup These Claims?

I’m not an economist, so I’m going to appeal to authority (and yes, I know that appealing to authority does not make an idea right or wrong).

The first guy to see this was a bond trader, not an economist. His name is Warren Mosler. He has since been given an honorary Ph.D. in Economics because he first saw how modern economies really work.

It does seem weird that it took a bond trader to see what economists did not, but I think it helps to understand he has an engineering mindset. While he does have a BA in economics, he studied engineering for two years, then switched his major to economics.

Warren Mosler figured out how our economy works by looking at it from an engineering perspective. In order to make better trades, he studied how the US Treasury, the US Federal Reserve, and the US commercial banking system shape our economy.

Warren Mosler made a lot of money on Wall Street. And he’s offered $100 million to be proven wrong. He still has that money. He has yet to be proven wrong.

If you want to understand these concepts better, watch the YouTube video linked to below. David Graeber is an Anthropologist who teaches at The London School of Economics and he’s talking about a book he wrote titled “Debt: The First 5,000 Years”.

For the first 21 minutes, he talks about how human cultures seem to universally equate debt with morality and how various early human cultures used debt (which I found fascinating).

At 21:07 minutes, he starts to describe the origin of money, about 6,000 years ago. To save you the trouble of listening to the first part, I start the video below at 21:07. You can back up to the start if you wish, but to understand the origin of money, you don’t have to.

When you understand why and how money was created in the first place (and it WAS NOT to be more efficient than barter), you suddenly see how what I’ve said above makes sense.

I would like to get out of the way that David Graeber seems to be a weird guy. But please don’t let that cloud your listening to him describe how money first came into existence within human society.

And…. once you’ve seen it, you can’t unsee it, and you find yourself wishing that everyone else saw it too.

To be clear, what I’ve said above is descriptive, not ideological. Independent of how we feel about how the economy SHOULD work, the issuer of a currency lives by one set of rules, and the users of that currency live by another.

We all benefit by knowing how this all works. It helps us detect when our political leaders are misleading us.

Modern Economies

I said earlier I would explain why modern economies consist of:

  • A fiat currency, which is not backed by any commodity such as gold or silver.
  • A floating exchange rate relative to other currencies.
  • A credit expansion banking system in which banks create and destroy money, by making and later retiring, loans.

These parts of this post are “under construction” and will come later.

Fiat currency: Why no more gold standard?

Why floating exchange rates?

Why credit expansion banking system?

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