How the U.S. Debt Works

U.S. DebtPolicymakers need to start being more honest about how the U.S. debt works.

It's an age-old debate among the members of Congress. How do we cut the budget? How do we reduce the debt?

But the argument over whether to raise taxes on the rich or cut spending to social programs is not the most frustrating part of this never-ending debate.

Rather, the whole debate is built off a misunderstanding of how the U.S. debt works and how the government spends money.

At best, Congress is ignorant of the process. At worst, they're fully aware of how the U.S. debt works and are simply molding their arguments to push a sinister political agenda.

Here's what no one in Congress is telling you about how the U.S. debt works...

How the U.S. Debt Works

The U.S. Federal Reserve acts as the U.S. government's banker. It is also the banker for the private sector's commercial banks and for foreign holders of U.S. dollars.

When the government wants to make a purchase, it simply wires money to a commercial bank and those funds are held as an overdraft in the commercial bank's reserve account at the Fed.

Let's say the U.S. government wanted to buy a weapons system from a defense contractor. They would wire those funds to the commercial bank holding that defense contractor's account. And the defense contractor could then withdraw those funds and convert them to cash, or more likely, let them sit in the commercial bank's reserves until they want to draw on them to pay a business expense.

Where did the U.S. government get that money in the first place? It wasn't drawing on tax money or surplus funds.

It simply changed numbers on a digital spreadsheet with keystrokes on a computer keyboard. If the weapons system cost $10 billion, the U.S. Treasury would simply mark up the reserve account of the bank $10 billion for the defense contractor.

That's all government spending is. The United States issues the dollar. It can create dollars out of thin air indefinitely. There is no spending constraint. Anyone who says the United States is running out of money or who thinks the U.S. government would be unable to pay back debt doesn't understand how the U.S. debt works.

That brings us to the issue of the $18.2 trillion debt.

Issuing U.S. debt is simply a way for the U.S. government to drain the private sector's aggregate reserve balances. Let's say that same defense contractor who just received $10 billion wanted to earn interest on that money. They could buy $10 billion worth of U.S. treasuries.

This is akin to the defense contractor simply moving the $10 billion in reserves to U.S. debt. Think of reserves as a checking account. And think of U.S. treasuries as a savings account. The defense contractor is simply moving its checking account to an interest-bearing savings account.

That's how the U.S. debt works. The U.S. government doesn't need to "pay back" its debt. It already paid for the weapons system. It gave the dollars to the defense contractor in the first place. All it needs to do is, at maturity, move that same $10 billion back into the defense contractor's checking account plus interest.

And that's assuming the defense contractor doesn't want to simply put that $10 billion plus interest right back into treasuries at maturity to earn even more interest.

The same applies for foreign governments. They too hold accounts at the Fed.

A lot has been made about the U.S. debt to China and the fears that China will at some point demand to have all the $1.3 trillion they hold in U.S. debt paid back to them.

"The only entity on the planet Earth that can create the dollar is the U.S. government. China can't," economist Michael Norman of told Money Morning. "We pay for everything. China sold us a bunch of t-shirts, flat-screen TVs, electronic components, toys, and textiles, and we pay for that in dollars. The dollars go into their account. And all dollars on deposit can only reside in one place, and that's at the Federal Reserve."

All China did in buying this debt was swap its dollars for treasuries. Paying off the debt is a matter of the U.S. Treasury making that swap in reverse.

The $18.2 trillion in debt is simply a reflection of how much money the global economy - primarily domestically but also abroad - has in dollar-denominated savings.

You see, the private sector can't create dollars. And by itself, it can't be a net saver. All the private sector can do is extend credit. If you take out a $10,000 loan, you'll have $10,000 in cash, but at the same time you'll have an offsetting liability.

When you look at the private sector as a whole, everybody's cash assets are offset by someone else's cash liabilities.

The only way for the private sector to be a net saver is if the U.S. government spends more money into the economy.

Any time the U.S. government has a surplus, that means the U.S. government has positive net savings and the private sector has negative net savings. If it has a deficit, the private sector has net savings.

When the U.S. government "rolls over" debt, it's simply "changing the composition of the financial assets of the public," Norman said.

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And it's done rather seamlessly. If you look at the U.S. Treasury's daily statements, you'll see that since the beginning of the fiscal year beginning on Oct. 1, 2014, the U.S. government has rolled over $51.8 trillion in debt.

This was largely from nonmarketable government account series debt, as the U.S. Treasury explained in an e-mail to Money Morning: "These securities are for federal agencies that have specific statutory authority to invest in these special non-marketable Treasury securities. Agencies can invest in overnight securities that redeem and re-issue each day unless an agency decides not to reinvest." This accounts for $46.7 trillion of those redemptions.

"That money is rolled right back again, usually into more treasuries," Norman said. "They're doing this on a daily basis and there's pretty much something going on every day... So these numbers add up" to many trillions.

The only true constraint on U.S. government spending is inflation. If it spends beyond the economy's capacity to produce, then inflation could kick in.

That's an entirely different debate, but it's the one Congress should be having - rather than questioning the U.S. government's ability to pay and threatening to default, as we've seen in the recent debates over raising the debt ceiling.

The Bottom Line: The U.S. debt is essentially the private and foreign sector's savings account to park dollars that the U.S. Treasury already spent. It's not about "paying back" or "paying off debt" as much as it is simply changing numbers on an electronic spreadsheet at the Fed. The Treasury can do this as much as it wants, and isn't constrained by the amount of tax revenue it takes in, or the amount of surplus funds it has. The only risk of a U.S. default would come from policymakers - ignorant of how the U.S. debt works - declaring that the seamless electronic transfer of funds between Fed accounts should stop.

Jim Bach is an Associate Editor at Money Morning. You can follow him on Twitter @JimBach22.

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