There has been a lot of confusion here in recent weeks with reference to several articles I have written on the creditworthiness of the United States (see here), the creditworthiness of the United States, and how an exchange rate monetary system floating non-convertible works. I have found that the overwhelming majority of investors think our government is limited in terms of income and indeed think we live in a convertible currency system similar to the gold standard or a commodity currency system. . It couldn’t be further from the truth. There are very important implications here in terms of what the government can do and how that will affect the future rate of inflation and the solvency of the United States. Warren Mosler was kind enough to convey this brief summary of the concept of vertical and horizontal money creation:

When the government “spends”, the treasury disburses the funds by crediting bank accounts. The settlement involves transferring reserves from the Treasury account at the Fed to the recipient’s bank. The resulting increase in the beneficiary’s deposit account has no corresponding responsibility in the banking system. This creation is said to be “vertical”, or exogenous to the banking system. As there is no corresponding liability in the banking system, this translates into an increase in non-government net financial assets.

When banks create money by providing credit (loans create deposits), this happens completely within the banking system and results in a liability for the bank (the deposit) and a corresponding asset (the loan). The client has an asset (the deposit) and a corresponding liability (the loan). It comes down to zero.

Thus, the vertical currency created by the government affects the net financial assets and the horizontal currency created by the banks does not, although its use in the economy as productive capital may increase real assets.

The mistake that is generally made is to compare what happens in the horizontal system with what happens at the level of public accounts. At the horizontal level, debt is the basis of horizontal money creation. Therefore, it is often assumed that debt should be the basis for the creation of money through the issuance of foreign currency by the government. This is not the case.

Reserve accounting uses standard accounting identities, but the meaning of “liability” is not “debt”. The husband-wife analogy for the accounting relationship between the Central Bank and the Treasury is appropriate. Since a husband and wife are responsible for each other’s debts, neither can be indebted to each other. That is, reserve accounting is a fiction that does not represent the real relationships, as they exist between a creditor and a debtor in the horizontal system.

Moreover, the public debt is not a real debt either. At the macro level, reserves that are transferred to banks through government disbursements are used to purchase treasury bills. That is, when a Treasury is purchased, it involves a transfer of reserves from the buyer’s bank reserve account to the Fed to the government account (consolidating the Central Bank and the Treasury as than “government”).

When treasury bills are sold or redeemed, reserves that were “stored” at interest are simply downgraded, again creating a deposit. It’s pretty much the same as buying and repurchasing a CD. It’s just a shift from demand to demand in a bank account, and a shift between reserves and government-level securities. That is, the government does not have to dip into income, borrow or sell assets to cover its “debt”, as households and businesses do. It is simply a matter of crediting and debiting accounts on the government (consolidated) books, although it may appear that there is a financial relationship between the BC and the Treasury due to the accounting. However, this is only a fiction.

Therefore, the key to understanding modern monetary theory is this vertical-horizontal relationship. When one understands this, then Abba Lerner’s principles of functional finance become evident. (1) Issuing foreign currency through government disbursements is used to increase non-government net financial assets, and taxation removes the net financial assets of non-governments. (2) The issuance of debt by the Treasury is a monetary operation to drain reserves to allow the Central Bank to reach its target rate.

These principles are then applied to Y + C + I + G + NX to balance nominal aggregate demand with actual production capacity in order to achieve full capacity utilization, hence full employment, as well as price stability. This is not based on a theory requiring assumptions, but on an operational reality that can be represented using data, standard accounting identities and consistent macroeconomic models between stocks and flows.

Perhaps most important in all of this is that it is not about “theory” at all. This is actually how the banking system works in a non-convertible floating exchange rate system. The United States government is never limited in its revenues. We do not “finance” our spending through taxes and debt issuance. China is not our banker. The fear campaign about government deficits and the issuance of government “debt” rests on a mountain of lies from people who do not understand how the monetary system works.

Of course, I don’t believe that gives the United States a ticket to spend (or print or “push a button” or whatever you want to call it) at will. It couldn’t be further from the truth. Spending has very real implications (although it is misinterpreted by most). I have argued and continue to argue that government spending is not the solution to all of our country’s problems. We have a private sector that remains deeply in debt, a highly deregulated banking system, a failing central bank, and a government that continues to promote a supposedly capitalist economy where losers never lose.

As the private sector continues to deleverage, let’s hope the government plays its part in helping to properly regulate the banking system in a way that ensures the American public can never be held hostage by the big banks again. Sadly, it looks like that day might be far away. In the meantime, the misconceptions that the United States is Greece, Weimar or Argentina will hopefully cease….

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The previous article is from one of our external contributors. It does not represent Benzinga’s opinion and has not been edited.

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About Ruben V. Albin

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